The Financial System. Sherif Khalifa. Sherif Khalifa () The Financial System 1 / 55

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1 The Financial System Sherif Khalifa Sherif Khalifa () The Financial System 1 / 55

2 The financial system consists of those institutions in the economy that matches saving with investment. The financial system channels funds from those who save to those with investment projects. These investment projects make the economy more productive. These projects provide new jobs for workers and introduce new products to consumers. By increasing an economy s productivity, the financial system helps the economy to grow and the living standards to increase. The financial system is comprised of the financial market and the financial intermediaries. Sherif Khalifa () The Financial System 2 / 55

3 Financial Markets are the institutions through which savers can directly provide funds to borrowers. Financial markets are markets in which people and entities buy and sell securities such as stocks and bonds. A security is a claim on some future flow of income. The most familiar securities are stocks and bonds. Sherif Khalifa () The Financial System 3 / 55

4 The primary market is that part of the capital market that deals with the issuance of new securities, where issuers can obtain funds through the sale of a new stock or bond issue. The issue of new securities is commonly known as an Initial Public Offering. In the primary markets, securities may be offered to the public in a public offer. The secondary market is the market for trading of securities that have already been issued in an initial private or public offering. Sherif Khalifa () The Financial System 4 / 55

5 A bond is a security issued by a corporation or a government that promises to pay the buyer predetermined amounts of money at certain times in the future. Corporations issue bonds to finance investment projects. Governments issue bonds to cover budget deficits. The bond issuer is borrowing money from those who buy the bonds. The bond issuer receives funds immediately and pays the buyers back in the future. The bond issuer owes money to bond purchasers, and bonds are called debt securities. Sherif Khalifa () The Financial System 5 / 55

6 Bonds A bond issuer defaults if it fails to make coupon payments or pay the face value at maturity. A corporation defaults if it declares bankruptcy, and a government defaults if it does not have enough revenues. The risk is smaller for bonds issued by the government or by well established successful corporations. The risk is larger for new corporations with unknown prospects or those that may go bankrupt. The greater the risk of default, the higher the interest rate that a bond must pay to attract buyers. Sherif Khalifa () The Financial System 6 / 55

7 A stock is an ownership share in a corporation. Stock is the capital raised by a corporation, through the issuance and sale of shares. A shareholder or a stockholder is any person or organization which owns shares of a corporation s stock. The stockholders are the owners of the corporation. A dividend is the distribution or sharing of parts of profits to a company s shareholders. Sherif Khalifa () The Financial System 7 / 55

8 Corporations issue stocks to finance investment projects. The earnings from a company s stock are a share of profits which are unpredictable. People buy stocks despite the risk because stocks produce higher returns. Stockholders also have ultimate control over a corporation. Sherif Khalifa () The Financial System 8 / 55

9 A stock exchange is an organization that provides a marketplace for trading shares, where investors may buy and sell shares in a wide range of companies. Allows companies to raise capital for expansion through selling shares to the investing public. Allows for a more rational allocation of resources because funds are redirected to promote business activity. By giving a wide spectrum of people a chance to buy shares, it helps to reduce large income inequalities. By having a wide and varied scope of owners, companies tend to improve on their effi ciency to satisfy the demands of these shareholders. Serves as a barometer of the economy, as the fluctuationsof share prices can be an indicator of the general trend in the economy. Sherif Khalifa () The Financial System 9 / 55

10 A bull market tends to be associated with increasing investor confidence, motivating investors to buy in anticipation of further capital gains. A bear market tends to be accompanied by widespread pessimism, and negative sentiments by investors. A stock market bubble takes place when a wave of public enthusiasm, evolving into herd behavior, causes an exaggerated bull market. A stock market crash is a sudden dramatic decline of stock prices. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles. Sherif Khalifa () The Financial System 10 / 55

11 Matching Savers and Investors A system of markets and institutions help channel funds from savers to investors. At any time, some people consume less than they earn and save the remainder. Other people know how to use these savings for investments that earn profits.. Financial markets transfer funds from an economy s savers to its investors. Sherif Khalifa () The Financial System 11 / 55

12 Risk Sharing If a person s wealth is tied to one company, the person loses a lot if the company is not successful. If the person buys the securities of many companies, the person diversifies. Diversification is the distribution of wealth among many assets. Diversification lets savers earn healthy returns from securities while minimizing the risk. Sherif Khalifa () The Financial System 12 / 55

13 Asymmetric information is a situation in which one participant in an economic transaction has more information than other participant. In financial markets, asymmetric information occurs because the sellers of securities have more information than the buyers. Two types of asymmetric information exist in financial markets: adverse selection and moral hazard. Sherif Khalifa () The Financial System 13 / 55

14 Adverse selection means that people or firms that are most eager to make a transaction are the least desirable to parties on the other side of the transaction. In securities markets, a firm is most eager to issue stocks and bonds if the values of these securities are low. This is the case if the firm s prospects are poor as earnings on its stocks are likely to be low and default risk on its bonds is high. Adverse selection is a problem for buyers of securities because they have less information than issuers about the securities value. Sherif Khalifa () The Financial System 14 / 55

15 Moral hazard is the risk that one party to a transaction will act in a way that harms the other party. In securities markets, issuers of securities may take actions that lowers the value of the securities. The buyers can not prevent this because they lack information on the issuer s behavior. Sherif Khalifa () The Financial System 15 / 55

16 Asymmetric Information Adverse Selection Moral Hazard Prior to a transaction, savers lack Information about investors characteristics After a transaction, savers do not observe investors behavior Investors with worst projects are most eager to sell securities Investors have incentives to misuse savers funds Savers won t buy securities Financial markets cannot channel funds from Savers to investors Sherif Khalifa () The Financial System 16 / 55

17 Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. A bank is a financial institution that raises funds by accepting deposits, and uses these funds to make loans to companies and individuals. Channeling funds through banks is called indirect finance. Channeling funds through financial markets is called direct finance. Banks combat adverse selection by screening potential borrowers. To combat moral hazard, banks include covenants about how the borrower is expected to behave. Sherif Khalifa () The Financial System 17 / 55

18 Asset Prices As the prices of stocks and bonds fluctuate, the owners of these assets see their wealth increase and decrease. As prices increase, asset owners increase consumption spending contributing to an expansion. As prices decrease, asset owners decrease consumption spending contributing to a contraction. Sherif Khalifa () The Financial System 18 / 55

19 Asset Prices The future value of a dollar is how many dollars it can produce in some future year. The present value of a future dollar is how much a future dollar is worth today. $ (1 + i) n in n years = $1 Today $ (1 + i) n $1 (1 + i) n in n years = (1 + i) n Today Present Value of $1 in n years = $1 (1 + i) n Today Sherif Khalifa () The Financial System 19 / 55

20 Asset Prices X Present Value = $X (1 + i) n Present Value = i = 4% n = 3 $100 ( ) 3 = $88.9 Sherif Khalifa () The Financial System 20 / 55

21 Asset Prices X 1 X 2 X 3 X T Present Value = $X 1 (1 + i) + $X 2 (1 + i) $X T (1 + i) T i = 4% n = 7 $X 1 = $X 2 =... = $X 7 = $23 Present Value = $23 (1.04) + $23 $ (1.04) (1.04) 7 = $138 Sherif Khalifa () The Financial System 21 / 55

22 Asset Prices X X X Present Value = $X (1 + i) + $X (1 + i) = $X i i = 4% $X = 100 Present Value = $ = $2500 Sherif Khalifa () The Financial System 22 / 55

23 Asset Prices X X(1+g) X(1+g) 2 X(1+g) 3 Present Value = $X $X (1 + g) $X (1 + g)2 + (1 + i) (1 + i) 2 + (1 + i) = $X i g Present Value = i = 4% $X = 100 g = 2% $ = $5000 Sherif Khalifa () The Financial System 23 / 55

24 Asset Prices Asset Price = Present Value of Expected Asset Income People purchase an asset because it yields a future stream of income. The present value tells us how much the income stream is expected to be worth and how much we should be willing to pay for the asset. If an asset s price is below the present value of its expected income stream, buyers pay less than the asset is worth. Lots of savers will purchase the asset, and high demand will push the price up. If an asset s price exceeds the present value of expected income, then sellers receive more than the asset is worth. The asset s owners will rush to sell it, and the increase in supply will push down the price. Sherif Khalifa () The Financial System 24 / 55

25 Asset Prices If a bond has a face value F, an annual coupon payment C, and a maturity T. Bond Price = F = $100, C = $5, T = 4 years, i = 4% C (1 + i) + C (1 + i) C + F (1 + i) T Bond Price = 5 ( ) + 5 ( ) ( ) ( ) 4 = $ Sherif Khalifa () The Financial System 25 / 55

26 Asset Prices If a stock pays dividends D 1 after one year, D 2 after two years, and so on. Stock Price = D 1 (1 + i) + D 2 (1 + i) Sherif Khalifa () The Financial System 26 / 55

27 Asset Prices An asset price is the present value of expected future income from the asset. Present value changes if expected income changes or if interest rates change. Changes in interest rates affect asset prices, as it represents the safe return. Expectations change when there are news about a company s prospects or about economic conditions. Higher expected earnings means larger expected dividends for stockholders, so the stock price increases. Lower expected earnings means lower expected dividends for stockholders, so the stock price decreases. Sherif Khalifa () The Financial System 27 / 55

28 Asset prices increase even though there is no change in interest rates or expected income to justify it. When a bubble occurs, an asset price increases simply because people expect it to increase. People would like to hold assets as long as prices increase but sell before the bubble bursts. A few asset holders get nervous and decide to start selling at one point in time. Others also sell hoping to dump their assets before prices fall too much. Panic sets as asset holders try to sell at the same time and prices Sherif Khalifa () The Financial System 28 / 55 Financial System Asset Prices An asset price bubble is trade in an asset at a price or price range that strongly exceeds the asset s intrinsic value. Bubbles are a self fulfilling prophecy.

29 Yield to Maturity If a bond has a face value F, an annual coupon payment C, and maturity T. Bond Price = C (1 + i) + C (1 + i) C + F (1 + i) T F = $100, C = $5, T = 4 years, Bond price= $95 $95 = 5 (1 + i) + 5 (1 + i) (1 + i) (1 + i) 4 i = Sherif Khalifa () The Financial System 29 / 55

30 Rate of Return P 0 : initial price of the security. P 1 : the price of a security after a year. X : direct payment. P 0 = $80, C = $4, P 1 = $82 Rate of Return = (P 1 P 0 ) P 0 + X P 0 Rate of Return = (82 80) = Sherif Khalifa () The Financial System 30 / 55

31 Yield Curve The yield curve shows interest rates on bonds of various maturities at a given point in time. The curve shows the relation between the interest rate and the time to maturity, known as the "term", of the debt. The yield curve s shape tells us about the expected path of interest rates. A steep curve means that the short term interest rates are expected to increase. An inverted curve means the short term interest rates are expected to decrease. Sherif Khalifa () The Financial System 31 / 55

32 Financial Crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. Sherif Khalifa () The Financial System 32 / 55

33 Financial Crisis Regulators encourage banks to be conservative in lending to avoid large losses. Banks deny credit to those who are likely to default including those with low income or poor credit histories. People who cannot borrow from banks turn to subprime lenders or finance companies. Government regulates finance companies less heavily as they do not accept deposits. So the government does not owe insurance payments if a finance company fails. Sherif Khalifa () The Financial System 33 / 55

34 Financial Crisis Subprime lending refers to loans to people who may have diffi culty maintaining the repayment schedule. These loans are characterized by higher interest rates, poor quality collateral, and less favorable terms in order to compensate for higher credit risk. Light regulation allows finance companies to make loans that regulators deem risky. Finance companies made loans to people who were likely to have trouble paying them back. Finance companies could offset expected losses from defaults by charging high interest rates. This led subprime lenders to neglect traditional safeguards against default like down payments. Sherif Khalifa () The Financial System 34 / 55

35 Financial Crisis The house price bubble was a key factor behind the subprime lending boom. House prices increased by more than 70% from 2002 to People believed that prices would continue to increase indefinitely. Increasing house prices made it easier for homeowners to cope with high mortgage rate payments. Someone can take out another mortgage because the higher value of the house offered more collateral. Someone can sell the house for more than he paid for it, pay off the mortgage, and earn a capital gain. Sherif Khalifa () The Financial System 35 / 55

36 Financial Crisis Banks sold many of the loans they make rather than holding them as assets. Banks sell loans because the possibility of default makes it risky to hold them. Banks and finance companies sold loans to a financial institution, the securitizer. By selling loans, the bank shifts default risk to the ultimate holders of the loan. The securitizer pays the bank for reducing asymmetric information problems. The bank earns a profit from the sale and avoids the likelihood of debt default. Sherif Khalifa () The Financial System 36 / 55

37 Financial Crisis Securitization is the process of taking an asset, or group of assets, and transforming them into a security. Securitization is the practice of pooling various types of contractual debt such as mortgages, auto loans or credit card debt obligations and selling their related cash flows to investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations. Investors are repaid from the principal and interest cash flows collected from the underlying debt. Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities. Sherif Khalifa () The Financial System 37 / 55

38 Financial Crisis The securitizer purchase home mortgage loans from the original lenders. The securitizer bundle a pool of mortgage loans with similar characteristics. The securitizer issue securities, referred to as mortgage backed securities. The securities entitle an owner to a share of the payments on the loan pool. The buyers became entitled to shares of the interest and principal payments. These are payments that borrowers made on mortgages they borrowed. Sherif Khalifa () The Financial System 38 / 55

39 As an underwriter, an investment bank helps companies issue new stocks and bonds. A firm becomes public by making a sale of stock, which is called an initial public offering. Investment banks advise companies, and markets the securities to potential buyers. Investment banks practice financial engineering, or the development and marketing of new types of securities. Sherif Khalifa () The Financial System 39 / 55 Financial Crisis An investment bank is an institution that provides financial services to individuals, corporations, and governments such as raising financial capital by underwriting or acting as the client s agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions and provide ancillary services such as market making, trading of derivatives and equity securities, and fixed income instruments, currencies, and commodities.

40 Financial Crisis In the early 2000s, the investment banks started to issue mortgage backed securities. The securities issued by investment banks had mortgages that were subprime. Subprime borrowers pay higher interest rates than traditional mortgage borrowers. Securities backed by subprime mortgages promised high returns to their owners. Securitization provided more funds for subprime lenders to issue more mortgage loans. This increased the demand for housing fueling the increase in the house prices. Sherif Khalifa () The Financial System 40 / 55

41 Financial Crisis Securities firms hold securities, trade them, or help others trade them. A large amount of mortgage backed securities were purchased by securities firms. Examples of securities firms include mutual funds, hedge funds, and index funds. Sherif Khalifa () The Financial System 41 / 55

42 Each shareholder owns a small part of the portfolio of securities in a fund. The shareholder of the mutual fund accepts the risk and return associated with the portfolio. If the value of the portfolio increases shareholders benefit, otherwise the shareholders suffer a loss. Allow people with small amounts of money to diversify their investments and face less risk. Give ordinary people access to the skills of professional fund managers. The government limits the risks that mutual funds can take with shareholders money. Sherif Khalifa () The Financial System 42 / 55 Financial Crisis Mutual funds is a financial institution that holds a diversified set of securities and sell shares to savers. Mutual fund is a professionally managed fund that pools money from many shareholders to purchase securities.

43 Financial Crisis Hedge funds raise pools of money to purchase securities. Hedge funds cater mainly to wealthy people and institutions. Hedge funds are largely unregulated because the fund s wealthy customers can look out for themselves. Light regulation means that hedge funds can make risky bets on asset prices. These bets sometimes produce large earnings and sometimes large losses. Sherif Khalifa () The Financial System 43 / 55

44 Financial Crisis A derivative is a contract that derives its value from the performance of an underlying entity. A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The payoffs from the derivative is tied to the prices of other assets. That is the value of the security is derived from other assets. Common types of derivatives are credit default swaps. A credit default swap buyer pays premiums as an insurance policy. Payments on credit default swaps are triggered by defaults on the original securities. Sherif Khalifa () The Financial System 44 / 55

45 Financial Crisis Many credit default swaps issued in the 2000s were tied to subprime mortgage backed securities. The sellers of CDS on mortgage backed securities promised to pay CDS buyers. If the market prices of the underlying securities fell even if the securities had not yet defaulted. Other firms used credit default swaps to speculate as they foresaw trouble in the housing market. They bet against mortgage backed securities by purchasing CDS on securities they did not own. As the financial crisis unfolded, insurance companies had to make payments to holders of its CDS. Sherif Khalifa () The Financial System 45 / 55

46 Financial Crisis A financial crisis is a major disruption of the financial system, and involves sharp falls in asset prices and failures of financial institutions. Sherif Khalifa () The Financial System 46 / 55

47 Financial Crisis Bubble Burst A crisis may be triggered by large decreases in the prices of stocks, real estate or other assets. Economists interpret these decreases as the end of asset price bubbles. A bubble occurs when asset prices increase above the present value of the expected income. As sentiment shifts, people begin to worry and start selling the assets pushing prices down. Falling prices shake confidence further, leading to more selling causing the bubble to burst. Sherif Khalifa () The Financial System 47 / 55

48 Financial Crisis Insolvencies An institution becomes insolvent when its assets fall below its liabilities and its net worth becomes negative. An institution may fail because it becomes insolvent. Insolvencies can spread from one institution to another. Because financial institutions have debts to one another. If one institution fails, its depositors and lenders suffer losses. Sherif Khalifa () The Financial System 48 / 55

49 Financial Crisis Liquidity Crises A financial institution can fail because it does not have enough liquid assets to make payments it promised. Depositors lose confidence in the bank, and try to withdraw large amounts from their accounts. This exhausts the bank s reserves and liquid securities, and the bank must sell its illiquid assets at low prices. If a bank experience a run, depositors at other banks start worrying about the safety of their own funds. The depositors start making withdrawals triggering an economy wide bank panic. Sherif Khalifa () The Financial System 49 / 55

50 Financial Crisis The real estate price increases were an unsustainable asset price bubble. The house price bubble burst, and house prices fell by 33% from 2006 to When house prices fell, homeowners found themselves with mortgage payments they could not afford. They could not borrow more and they could not sell their houses for enough to pay their mortgages. The decline in house prices caused defaults on subprime mortgages as borrowers could not make payments. As defaults on subprime mortgages increase, institutions that made subprime loans suffered large losses. Other financial companies that held securities backed by subprime mortgages lost billions of dollars. Participants in financial markets realized that subprime mortgage backed securities would produce less than expected. Sherif Khalifa () The Financial System 50 / 55

51 Financial Crisis The direct costs of financial crises include losses to asset holders when asset prices fall, and losses from financial institution failures. Owners of a failed institution lose their equity, and the institution s creditors lose funds they have lent. The indirect cost is that a crisis can set off a chain of events that plunges the whole economy into a recession. Falling asset prices cause a sharp fall in aggregate demand, as asset holders decrease consumption as they suffer loss of wealth. Falling asset prices shake the confidence of firms and consumers as signs that the overall economy is in trouble. Sherif Khalifa () The Financial System 51 / 55

52 Financial Crisis Uncertain of the future, they put off major decisions about consumption and investment spending. A fall in asset prices makes it harder for individuals and firms to borrow. Lower house prices decreases the value of the borrowers collateral. The outcome is a credit crunch, or a sharp decrease in bank lending. Failures of financial institutions also cause a credit crunch, as when commercial banks fail they stop lending. Surviving banks may fear failure and become more conservative in approving loans. This also means less spending by firms and individuals who rely on credit. Sherif Khalifa () The Financial System 52 / 55

53 Financial Crisis This decrease in consumption and investment decreases aggregate demand. A fall in aggregate demand lowers output, and a crisis can cause a deep recession. The recession can exacerbate the crisis, as asset prices are likely to fall further. A financial crisis can trigger a vicious circle, and once a crisis starts it can sustain itself for a long time. Sherif Khalifa () The Financial System 53 / 55

54 Financial Crisis Sherif Khalifa () The Financial System 54 / 55

55 Sherif Khalifa () The Financial System 55 / 55

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