Chapter 4

Financial Economics

• – – – – – – What is the Purpose of a financial system?

The

financial system

provides channels to transfer funds from individuals and groups who have saved money to individuals and groups who want to borrow money.

Savers

are suppliers of funds, providing funds to borrowers in return for promises of repayment of even more funds in the future.

Borrowers

are demanders of funds for consumer durables, houses, or business plant and equipment, promising to repay borrowed funds based on their expectation of having higher incomes in the future.

The promises of repayment that borrowers give to savers are

liabilities

to the borrowers and

assets

to the savers.

Financial markets

savers.

issue claims on individual borrowers directly to

Financial institutions

to savers. or

intermediaries

act as go-betweens by holding a portfolio assets and issuing claims based on that portfolio

•

Services

• •

Risk sharing - diversification Liquidity – ease at which a financial instrument can be turned into cash

•

Information

•

– – Financial Markets – systems where money flows from savers to borrowers Function

• – –

Transfer funds from savers to borrowers

Direct finance – Savers lend to the borrowers Indirect finance – through a financial intermediary

Financial Intermediary – facilitates the flow of funds

–

•

Debt instruments – Bonds – a loan to borrower

– – – – – –

Bonds

are debt instruments that may be issued by domestic or foreign governments and corporations Maturity date – expiration date • short term – less than a year • intermediate – 1 to 10 years • long – 10+ Perpetuities – have no maturity dates, pay interest forever Coupons – fixed interest paid on Bonds Zero coupons – sold below stated value Can be tax exempt – municipal bonds Bonds are rated by

Standards & Poor’s Investors Service

and

Moody’s

• – – – – –

Mortgages – loans for property (real estate)

Mortgages

are long-term debt instruments used to purchase residential, commercial, and farm properties. The underlying property serves as

collateral

. Fixed rate – fixed interest rate Adjustable rate – interest rate changes with the market about every six months The principal and interest payments may be insured by the

Federal Housing Administration

(

FHA)

or

Veterans Administration

government. (

VA)

, which are agencies of the federal

Conventional loans

mortgage insurance.

have no federal insurance and are made by financial institutions and mortgage brokers. Lenders may require borrowers with conventional loans to obtain private

– Equities • – Stocks (Ownership): Stocks represent equity in a corporation Firms issue stock to raise funds for long-term investment spending.

• An

initial public offering (IPO)

issued stocks by a corporation that has not previously sold stocks to the public. A newly issued stocks by a firm that has publicly held stocks outstanding.

is a public offering of newly

seasoned stock offering

is an offering of •

Program trading

by institutional investors allows for the pre programming of computers to buy or sell baskets of stocks.

• Buying stocks on the

margin requirement margin

refers to putting up only a fraction of the stock’s selling price and borrowing the rest. Currently, the set by the Fed is 50 percent.

• Stocks may be traded in organized markets such as the

New York Stock Exchange (NYSE)

, the

American Stock Exchange

, or other regional stock exchanges. Organized exchanges operate auction-type markets where a specialist trades large blocks of shares.

• • • • • • • • The NYSE is by far the largest organized exchange. Each stock is traded at a specific post, which may trade up to several dozen stocks.

The NYSE also enforces

circuit breakers

to temporarily halt market trading if stock prices change by a specified amount.

The

over-the-counter market

is an informal network of market makers who trade stocks via telephone or computer linkages.

Stocks of over 30,000 companies are traded over the counter.

The

National Association of Securities Dealers (NASD),

privately owned organization, regulates the over-the-counter market under the supervision of the SEC.

a Large companies may also be NASDAQ.

National Association of Securities Automated Quotation System (NASDAQ)

members. Stocks of NASDAQ members are traded on an advanced computer system that provides price quotes for the members of

Stock market indexes

measure movements in overall stock prices of the stocks included in the index.

The

Dow Jones Industrial Average

(the

Dow)

is an index of stocks of 30 of the largest companies in the country.

– The •

S&P 500

is a weighted average of stocks of 500 broad based companies and is considered to be a more meaningful index than the Dow.

– Dividend Types Preferred stock – get fixed dividends and are paid first • Common stock – get what is left if any –

Beta

measures the variability of a stock’s return relative to the entire market. A beta of 1 means that if there is a 1 percent price change in the overall market, this stock’s price also changes by 1 percent. A beta of 2 means that if there is a 1 percent price change in the overall market, this stock’s price changes by 2 percent and the stock is riskier than the market. A beta less than 1 means that the price of the stock’s price varies less than the overall market.

– Types • Rising – bull • Falling – bear

Primary Market

– • • • • • • Primary – initial offering (IPO):

Primary markets

are those in which newly issued claims are sold to initial buyers by the borrower The most commonly used claim is

debt

, which requires the borrower to repay the

principal

plus

interest.

– The length of the period of time before a debt instrument expires is its maturity.

Short-term debt

instruments have a maturity of less than one year.

–

Intermediate term debt

years.

instruments have a maturity between one year and 10 – –

Long-term debt

instruments have a maturity of 10 years or more.

Debt instruments offer the advantage to the borrower that they need not pay more than the amount promised, while lenders incur the risk of receiving back less than the amount promised if borrowers

default

.

Equity allows for variable payments from the borrower to the lender.

Common stock is a good example of an equity.

Equity owners generally receive periodic payments from the firm, known as

dividends

.

– – Done by an Investment bank (underwriter) who then sells it to the public Morgan Stanley, Merrill Lynch, Smith Barney Act as brokers and dealers

Secondary Market

– • • • • • • • • Secondary – any additional trading of the financial instrument Risk-sharing, liquidity, and information services are provided in

secondary markets

.

Smoothly functioning secondary markets make it easier for investors to reduce their exposure to risk by holding a diversified portfolio of stocks, bonds, and other assets.

Secondary markets promote liquidity by making it easier for investors to sell financial instruments for cash.

Secondary markets convey information to both savers and borrowers by determining the prices of financial assets.

New York Stock Exchange Brokers – agents of investors Dealers – link buyers and sellers – – Bid ask spread Bid – price dealers will buy (low) $50 Ask or Offer – Price dealers will sell (high) $52

•

Markets

– Auction Markets (Exchanges) – buyers and sellers confront directly • – Dealer Markets (Over the Counter) – Dealers carry an inventory (like a store) in hopes of making a profit • NYSE, Chicago commodity market, NASDAQ Use computerized trading • – Brokered Market – dealers and brokers search for buyers and sellers and earn a commission • Over the Counter (OTC) and NASDAQ Municipal Bonds

• •

Time Markets – deal with maturity

– Money Market – short term instruments (less than 1 year) • • Less risky More liquid • Lower information costs – Capital Market – long term instruments (1+ years)

Claims

– Cash market – immediate transaction and settlement – Derivative market- settlement is made later • Financial futures – commodities and metals • Options – the right to buy or sell and asset in the future

Financial Instruments

– • • • • • • • Money Markets – – U.S. Treasury Bills – short term Govt issues (3 to 12 months) No default – raise taxes or print currency Used in Open Market Operations • Third largest – Sell at discount Certificates of deposits – short term bank issue – – second largest $100,000 – First issued by Citibank in 1971 Commercial paper – short term corporate issues – largest Banker’s Acceptances – international trade issue Repurchase agreement – guaranteed issue of less than two weeks by large corporations and governments with short term extra money (usually hours) – seller agrees to buy it back at a higher price Federal Funds – overnight loans between banks – Federal Funds Rate Eurodollars – US dollars in foreign banks – Not Euros

– – • • • • • • • • • Capital Markets Stocks – ownership of a corporation – Price = f(interest rates, company earnings) • Influenced by monetary policy which determines interest rates, GDP and inflation – – Largest The principal of

inflation-indexed bonds

change, the coupon payment is based on the inflation-adjusted amount and the investor receives the inflation-adjusted principal at maturity.

is adjusted for inflation every six months. Although the interest rate doesn’t – Mortgages – loans to purchase homes or land Second largest – Corporate bonds – loans to corporations Third largest – US Government securities – savings bonds Types • • Treasury Notes – 1 to 10 years Treasury Bonds – 10+ years – Most liquid – US Government Agency Securities – issued by agencies to finance loans for housing, farm loans etc.

Government agency securities

are securities issued by government-sponsored enterprises and by the Federal Financing Bank.

–

Government-sponsored enterprises

such as

Fannie Mae, Freddie Mac

, and

Ginnie Mae

, are privately owned but have been chartered by Congress to reduce the cost of borrowing in such sectors as housing, farming, and student loans State and Local (municipal) Government Bonds – to finance schools and bridges etc.

– – Revenue – has specific goal General Obligation bonds Consumer and Commercial bank loans – to households and businesses International Markets – Foreign Bonds – from other countries Eurobond – recent type and most popular World Stock markets

Financial Institutions

– • Financial Intermediaries – Financial Intermediaries in the Financial System Institutions that raise funds from savers and invest in the debt or equity claims of borrowers are engaged in

financial intermediation

.

– Financial intermediaries match savers and borrowers by pooling the funds of many savers to lend to many individual borrowers.

– Financial intermediaries provide risk-sharing, liquidity, and information services.

• Banks provide risk-sharing to individual depositors by having a large quantity of deposits and access to numerous borrowers and investments.

• • Bank deposits and other intermediary claims are liquid.

Because banks collect and process information on behalf of many depositors their costs for information gathering are lower than would be those of individual depositors and 13 [d1] RSU Chapter 3

•

Functions

– Reduce transactions costs – make trading easier – Provide risk sharing, liquidity and information – Volume of activity allows economies of scale – Portfolio Diversification – don’t put all of your eggs in one basket

• –

Obstacles to Matching Savers and Borrowers

Transactions costs

are the costs of buying and selling a financial instrument.

• Brokerage commissions, minimum investment requirements, and lawyers’ fees are all examples of transactions costs.

• Financial intermediaries reduce transactions costs by exploiting

economies of scale

.

–

Information costs

are the costs that savers incur to determine the credit-worthiness of borrowers and to monitor how borrowers use the acquired funds.

•

Asymmetric information

describes the situation in which one party in a transaction has better information than the other. One party knows more than the other (insurance).

• •

Adverse selection

refers to a lender’s problem of distinguishing the good-risk applicants from the bad-risk applicants before making an investment. The people who need money are generally those with bad credit

Moral hazard

refers to a lender’s verifying that borrowers are using their funds as intended. Loan is said to be for one purpose but actually used for another

– • • • • • • • • • • Depository Institutions –

Commercial banks

are financial intermediaries that accept deposits and make loans, offering risk-sharing, liquidity, and information services to savers and borrowers.

Borrowers with small or medium-sized credit needs do not rely on stock or bond markets because these markets have high transactions and information costs.

– In the United States,

savings institutions

(such as savings and loan institutions) originated as building and loan societies.

Savings institutions historically suffered from a maturity mismatch, which led to a crisis in the U.S. deposit insurance system during the 1980s and early 1990s.

Credit unions

take deposits from and make loans to individuals who work at the same firm or in the same industry Thrift institutions Savings and loans – mortgages Mutual savings banks – mortgages Credit unions – consumer loans Commercial banks (largest) – all types of loans 8,000 Declining percent of financial share

• – – – Contractual Savings Institutions allow individuals to pay money to transfer risk of financial hardship to someone else and to save in a disciplined manner for retirement.

• •

Insurance companies

are financial intermediaries that specialize in writing contracts to protect their policyholders from the risk of financial loss associated with particular events.

Insurance companies are able to engage in risk pooling because the “law of large numbers” states that the average occurrences of death, illness, or injury for large groups of people can generally be predicted.

Insurance companies face problems of adverse selection and moral hazard, which they attempt to alleviate through screening potential policyholders and through the use of

risk-based premiums

,

deductibles

,

coinsurance

, and

restrictive covenants

.

• •

Life insurance companies

provide insurance to protect against financial hardship for the policyholder’s survivors.

With “whole life insurance” policyholders can save for the future, withdrawing the total “cash value” at retirement or turning that value into an “annuity.” With “term life insurance” premiums rise with age and the policy pays off only at the death of the policyholder.

• P

roperty and casualty insurance companies

insure policyholders against events other than death.

• • • – –

Life Insurance companies – corporate bonds and mortgages

Whole Life – builds cash value, constant premium Term Life – no cash value, premium rises as you get older (very low in the beginning)

Fire and casualty insurance companies – Government bonds (all types)

– –

Pension funds (largest) and government retirement funds – corporate stocks and bonds

Private funds growing the fastest

Pension funds

provide for pension benefit payments during workers’ retirements.

invest contributions of workers and firms to

– Investment intermediaries – also growing •

Investment institutions

, which raise funds to invest in loans and securities, include mutual funds and finance companies.

• • • – –

Mutual funds

are financial intermediaries that convert small individual claims into diversified portfolios of stocks, bonds, mortgages, and money market instruments.

Mutual funds

a few stocks.

are investment companies that pool the funds of many investors and purchase securities that allow for much greater diversification than an investor could achieve on his/her own.

Mutual funds

pool the funds of many investors to invest in several hundred or even thousands of stocks or bonds offering greater safety and more diversification than investing in one or Mutual funds now offer

indexed mutual funds

stocks as represented in a stock index. Returns to an indexed fund should mirror returns to the index.

that hold the same basket of .

Exchange Traded Funds (ETFs)

are securities created by a securities firm that deposits a large basket of stocks into a fund. The basket of stocks in the fund mirrors the holdings of stocks in an index. Shares in an EFT are then issued against the basket of stocks, sold to individual investors, and traded like shares of stock on an exchange. The return on ETFs mirror the return of the index.

• • • • • • In

closed-end mutual funds

the-counter markets. , the mutual fund company issues a fixed number of nonredeemable shares, which investors may then trade in over-

Closed-end investment companies

supply and demand and can differ from the net asset value.

sell a limited number of shares that may be traded openly. The price is determined by

Open-end mutual funds

issue redeemable shares at a price tied to the underlying value of the assets. An

open-end fund

shares or buys outstanding shares from the public at the The net asset value per share is the difference between the market value of the shares of stock that the fund owns and the fund’s liabilities, all divided by the outstanding number of shares continually sells new

net asset value

. While most mutual funds are called

no-load funds

and earn income only from management fees, some mutual funds are

load funds

and charge commissions for purchases and sales.

Pooled funds that are invested by a manager Families –different funds managed under the same umbrella) – Fidelity, Vanguard Group Specialized funds – growth, bond, index

• • • • • •

Finance companies

are intermediaries that raise large amounts of money through the sale of commercial paper and securities in order to make small loans to households and businesses.

Finance companies – consumer and business loans Money market mutual funds – Money market instruments Short term money market instruments

Money market mutual funds

invest in securities with an original maturity of one year or less The greatest growth in mutual funds has been in

money market mutual funds

, which hold high quality, short-term assets

– • • • Securities market institutions • Investment banks underwrite newly distributed stocks and bonds Morgan Stanley, Merrill Lynch, Smith Barney Profit on a “spread” determined by risk Brokers and Dealers:

Brokerage firms

(

brokers

and

dealers

) facilitate the trading of securities in secondary markets. Dealers take positions in securities to insure the smooth functioning of secondary markets.

•

Market orders

direct the broker or dealer to purchase securities at the present market price. •

Limit orders

instruct the broker or dealer either to purchase the securities at the market price up to a certain maximum if possible or to sell the securities at the market price if it is above a certain minimum.

• • • • •

Securities market institutions

reduce the costs of matching savers and borrowers and provide risk sharing, liquidity, and information services.

Investment banks

capital in primary markets and advise on the best way to do so.

assist business in raising new One way in which investment bankers earn income is by

underwriting

a firm’s new stock or bond issue.

Rather than guaranteeing the price of an issue, as is done with underwriting, an investment bank might sell the issue under other conditions, such as on an “all-or-none” basis.

Large issues are sold by groups of underwriting investment banks called

syndicates

.

• • • • • • • • • The ability to buy and sell issues at low cost after their original issue increases their liquidity.

Brokers and dealers facilitate the exchange of securities in financial markets by locating buyers when sellers want to convert securities to cash.

Brokers

earn commissions by matching ultimate buyers and sellers in a particular market.

Dealers

trade between ultimate buyers and sellers.

The SEC regulates dealers and brokers and restricts trading based on

insider information

.

Securities may be traded through exchanges or in over-the-counter markets.

An

exchange

is a physical location at which securities are traded.

In

over-the-counter (OTC) markets

broker-dealers match buyers and sellers over the telephone and by computer.

While the market for U.S. Treasury bonds is the most liquid market in the world, the market for most corporate bonds is relatively illiquid.

– Venture Capitalists – finance risky startups • Nonpublic – Government Financial Institutions • Federal credit agencies are

institutions

policy.

government financial

that make loans in the interest of public • The U.S. government lends to farmers through the Farm Credit System, to the housing market through the Federal National Mortgage Association, the Federal Home Loan Mortgage Company, and the Government National Mortgage Association, and to students through the Student Loan Market Association.

• The U.S. government also guarantees loans made by private financial institutions

Financial Regulation

– • • • • • Facts Governments around the world regulate financial markets and institutions in order to promote the provision of information, the maintenance of financial stability, and other policy objectives.

The federal government in the United States has intervened in financial markets to require issuers of financial instruments to disclose information about their financial condition.

Most regulation of the financial system is aimed at ensuring financial stability in the sense of maintaining the ability of the financial system to provide risk-sharing, liquidity, and information services in the face of economic disturbance.

Other policy objectives advanced by financial regulation include controlling the money supply and encouraging particular activities.

Regulation affects the ability of financial markets to provide risk sharing, liquidity, and information services

– Goals

• • • •

Provide information Maintain financial stability Control the money supply Encourage particular activities

– • • • • Major agencies SEC – organized exchanges and financial markets – – Established by the Securities Acts of 1933 and 1934 Primary Markets – Regulates • Public Disclosure • Insider Trading NASD – National Association of Securities Dealers FDIC – Commercial banks, Savings and loans and Mutual savings banks – $100,000 per account Federal Reserve System (FED) – all depository institutions – • • • • • • • • Functions • Increase investor information • Ensure soundness of the intermediaries • Examines banks Restricts entry Disclosure – reporting requirements Restricts assets and activities Deposit insurance Limits competition Restricts interest rates – Regulation Q Reserve requirements Control Monetary Policy

• – – – – – – – Competition and Change in the Financial System • • Financial markets and financial intermediaries compete for funds and market share in the financial system by offering risk-sharing, liquidity, and information services to savers and borrowers.

Financial innovation

sharing, liquidity, and information services or from changes in demand for these services.

results from changes in the costs of providing risk The increasing ease of communicating information has allowed for greater

financial integration

between U.S. financial markets.

In recent decades there has been global integration of financial markets.

The easy flow of capital across national boundaries helps countries with productive opportunities to grow.

Increasing financial integration around the world reduces the cost of allocating savers’ funds to the highest-valued uses.

During the 1930s, laws and regulations built barriers that protected from competition the services offered by each type of financial institution.

In the current environment, the provision of financial services is being organized more by function than by the identity of the provider.

The

Gramm-Leach-Bliley Financial Services Modernization Act of 1999

removed many of the regulatory lines among financial institutions.