Introduction. Why study Financial Markets and Institutions? Primary versus Secondary Markets. Financial Markets

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1 Why study Financial Markets and Institutions? Introduction Markets and institutions are primary channels to allocate capital in our society Proper capital allocation leads to growth in: Societal Wealth Income Economic opportunity 1-2 Financial Markets Primary versus Secondary Markets Financial markets are one type of structure through which funds flow Financial markets can be distinguished along two dimensions: primary versus secondary markets money versus capital markets Primary markets markets in which users of funds (e.g., corporations and governments) raise funds by issuing financial instruments (e.g., stocks and bonds) Secondary markets markets where financial instruments are traded among investors (e.g., NYSE and Nasdaq)

2 Primary versus Secondary Markets Primary versus Secondary Markets Do secondary markets add value to society or are they simply a legalized form of gambling? How does the existence of secondary markets affect primary markets? Money versus Capital Markets Foreign Exchange (FX) Markets Money markets markets that trade debt securities with maturities of one year or less (e.g., CDs and U.S. Treasury bills) little or no risk of capital loss, but low return Capital markets markets that trade debt (bonds) and equity (stock) instruments with maturities of more than one year substantial risk of capital loss, but higher promised return FX markets trading one currency for another (e.g., dollar for yen) Spot FX the immediate exchange of currencies at current exchange rates Forward FX the exchange of currencies in the future on a specific date and at a pre-specified exchange rate

3 Derivative Security Markets Derivative Security Markets Derivative security a financial security whose payoff is linked to (i.e., derived from) another security or commodity, generally an agreement to exchange a standard quantity of assets at a set price on a specific date in the future, the main purpose of the derivatives markets is to transfer risk between market participants. Selected examples of derivative securities Exchange listed derivatives Many options, futures contracts Over the counter derivatives Forward contracts Forward rate agreements Swaps Securitized loans Derivatives and the Crisis Derivatives and the Crisis 1. Mortgage derivatives allowed a larger amount of mortgage credit to be created in the mid-2000s. 2. Mortgage derivatives spread the risk of mortgages to a broader base of investors. 3. Change in banking from originate and hold loans to originate and sell loans. Decline in underwriting standards on loans 1. Subprime mortgage losses have been quite large, reaching over $700 billion. 2. The Great Recession was the worst since the Great Depression of the 1930s. Trillions $ global wealth lost, peak to trough stock prices fell over 50% in the U.S. Lingering high unemployment in the U.S. Sovereign debt levels in developed economies at alltime highs

4 Financial Institutions (FIs) Asset Size and Number of Selected U.S. Financial Institutions 2010 Financial Institutions institutions through which suppliers channel money to users of funds Financial Institutions are distinguished by: whether they accept insured deposits, depository versus non-depository financial institutions whether they receive contractual payments from customers. INSTITUTION TOTAL ASSETS (BILL $) NUMBER OF FEDERALLY INSURED INSTITUTIONS Commercial Banks $12,130 6,622 Savings Associations $ 1,253 1,138 Credit Unions $ 885 7,554 Insurance Companies $ 6,459 Private Pension Funds $ 5,661 Finance Companies $ 1,613 Mutual Funds $ 7,376 Money Market Mutual Funds $ 2,746 Data from September 2010, data sources include Federal Reserve Board, Flow of Funds Accounts, Levels Tables, FDIC Stats at a Glance and the NCUA website. The mutual funds category excludes money market funds Non-Intermediated (Direct) Flows of Funds Flow of Funds in a World without FIs Users of Funds (corporations) Direct Financing Financial Claims (equity and debt instruments) Cash Suppliers of Funds (households) Intermediated Flows of Funds Flow of Funds in a World with FIs Users of Funds Cash Financial Claims (equity and debt securities) Intermediated Financing FIs (brokers) FIs (asset transformers) Suppliers of Funds Cash Financial Claims (deposits and insurance policies)

5 Depository versus Non-Depository FIs FIs Benefit Suppliers of Funds Depository institutions: commercial banks, savings associations, savings banks, credit unions Non-depository institutions Contractual: insurance companies, pension funds, Non-contractual: securities firms and investment banks, mutual funds. Reduce monitoring costs Increase liquidity and lower price risk Reduce transaction costs Provide maturity intermediation Provide denomination intermediation FIs Benefit the Overall Economy Risks Faced by Financial Institutions Conduit through which Federal Reserve conducts monetary policy Provides efficient credit allocation Provide for intergenerational wealth transfers Provide payment services Credit Foreign exchange Country or sovereign Interest rate Market Off-balance-sheet Liquidity Technology Operational Insolvency

6 Regulation of Financial Institutions Globalization of Financial Markets and Institutions FIs are heavily regulated to protect society at large from market failures Regulations impose a burden on FIs and before the financial crisis, recent U.S. regulatory changes were deregulatory in nature Regulators attempt to maximize social welfare while minimizing the burden imposed by regulation The pool of savings from foreign investors is increasing and investors look to diversify globally now more than ever before, Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access, International mutual funds allow diversified foreign investment with low transactions costs, Global capital flows are larger than ever FIs and the Crisis FIs and the Crisis Timeline of events Home prices decline in late 2006 and early 2007 Delinquencies on subprime mortgages increase Huge losses on mortgage-backed securities (MBS) announced by institutions Bear Stearns fails and is bought out by J.P. Morgan Chase for $2 a share (deal had government backing). Timeline of events September 2008, the government seizes governmentsponsored mortgage agencies Fannie Mae and Freddie Mac The two had $9 billion in losses in the second half 2007 Now run by Federal Housing Finance Agency (FHFA) September 2008, Lehman Brothers files for bankruptcy; Dow drops 500 points

7 FIs and the Crisis FIs and the Crisis Government Rescue Plan Government Rescue Plan

8 Government Rescue Plan Determinants of Interest Rates 1-29 Interest Rate Fundamentals Real Interest Rates Nominal interest rates: the interest rates actually observed in financial markets Used to determine fair present value and prices of securities Two types of components Opportunity cost Adjustments for individual security characteristics Additional purchasing power required to forego current consumption What causes differences in nominal and real interest rates? If you wish to earn a 3% real return and prices are expected to increase by 2%, what rate must you charge? Irving Fisher first postulated that interest rates contain a premium for expected inflation

9 Loanable Funds Theory Supply and Demand of Loanable Funds Loanable funds theory explains interest rates and interest rate movements Views level of interest rates in financial markets as a result of the supply and demand for loanable funds Domestic and foreign households, businesses, and governments all supply and demand loanable funds Interest Rate Demand Supply Quantity of Loanable Funds Supplied and Demanded Determinants of Household Savings Determinants of Foreign Funds Invested in the U.S. 1. Interest rates and tax policy 2. Income and wealth: the greater the wealth or income, the greater the amount saved, 3. Attitudes about saving versus borrowing, 4. Credit availability, the greater the amount of easily obtainable consumer credit the lower the need to save, 5. Job security and belief in soundness of entitlements, 1. Relative interest rates and returns on global investments 2. Expected exchange rate changes 3. Safe haven status of U.S. investments 4. Foreign central bank investments in the U.S

10 Determinants of Foreign Funds Invested in the U.S. Shifts in Supply and Demand Curves change Equilibrium Interest Rates Country Foreign Currency Reserves (all $ in billions) China $2,847 Saudi Arabia 456 Russia 444 Taiwan 382 S. Korea 292 Source: Economist, February 2011 Increased supply of loanable funds Interest Rate i* i** DD E SS E* SS* Increased demand for loanable funds Interest Rate DD DD* SS i** i* E E* Q* Q** Quantity of Funds Supplied Q* Q** Quantity of Funds Demanded Factors that Cause Supply and Demand Curves to Shift Factors that Cause Supply and Demand Curves to Shift Affect on Supply Affect on Demand Wealth & income Increase N/A As wealth and income increase, funds suppliers are more willing to supply funds to markets. Result: lower interest rates Risk D ecrease Decrease As the risk of an investment decreases, funds suppliers are less willing to purchase the claim. All else equal, demanders of funds would be less willing to borrow as well. Result: higher interest rates Near term spendi ng needs Decrease N/A As current spending needs increase, funds suppliers are less willing to invest. Result: higher interest rates Monetary expansion I ncrease N/A As the central bank increases the supply of money in the economy, this directly increases the supply of funds available for lending. Result: lower interest rates Affect on Supply Affect on Demand Economic growth Increase Increase With stronger economic growth, wealth and incomes rise, increasing the supply of funds available. As U.S. economic strength improves relative to th e rest of the world, foreign supply of funds is also increased. Business demand for funds increases as more projects are profitable. Result: indeterminate effect on interest rates, but at more rapid growth rates interest rates tend to rise. Utility derive d from assets Decrease Increase As utility from owning assets increases, funds suppliers are less willing to invest and postpone consumption whereas funds demanders are more willing to borrow. Result: higher interest rates Restrictive covenants Increase Decreas e As loan or bond covenants become more restrictive, borrowers reduce their demand for funds. Result: lower interest rates

11 Factors that Cause Supply and Demand Curves to Shift Determinants of Interest Rates for Individual Securities Affect on Supply Affect on Demand Tax Increase Decrease Increase Taxes on interest and capital gains reduce the returns to savers and the incentive to save. The tax deductibility of interest paid on debt increases borrowing demand. Result: Higher interest rates Currency Appreciation Increase N/A Foreign suppliers of funds would earn a higher rate of return if the currency appreciates and a lower rate of return measured in their own currency if the dollar depreciates. Foreign central banks often buy U.S. Treasury securities as part of their attempts to prevent their currency from appreciating against the dollar. Result: Lower interest rates Expected inflation Decrease Increase An increase in expected infl ation implies that suppliers will be repaid with dollars that will have less purchasing power than originally anticipated. Suppliers lose purchasing power and borrowers gain more than originally anticipated. This implies that supply will be reduced and d emand increased. Result: Higher interest rates i j * = f(ip, RIR, DRP j, LRP j, SCP j, MP j ) Inflation (IP) IP = [(CPI t+1 ) (CPI t )]/(CPI t ) x (100/1) Real Interest Rate (RIR) and the Fisher effect RIR = i Expected (IP) Determinants of Interest Rates for Individual Securities (cont d) Term Structure of Interest Rates: the Yield Curve Default Risk Premium (DRP) DRP j = i jt i Tt i jt = interest rate on security j at time t i Tt = interest rate on similar maturity U.S. Treasury security at time t Liquidity Risk (LRP) Special Provisions (SCP) Term to Maturity (MP) Yield to Maturity (a) (b) Time to Maturity (c) (a) Upward sloping (b) Inverted or downward sloping (c) Flat

12 Unbiased Expectations Theory Liquidity Premium Theory Long-term interest rates are geometric averages of current and expected future short-term interest rates 1/ N R [(1 R )(1 E( r ))...(1 E( r ))] 1 1 N N 1 1R N = actual N-period rate today N = term to maturity, N = 1, 2,, 4, 1R 1 = actual current one-year rate today E( i r 1 ) = expected one-year rates for years, i = 1 to N Long-term interest rates are geometric averages of current and expected future short-term interest rates plus liquidity risk premiums that increase with maturity 1/ N R [(1 R )(1 E( r ) L )...(1 E( r ) L )] 1 1 N N 1 N L t = liquidity premium for period t L 2 < L 3 < <L N Market Segmentation Theory Implied Forward Rates Individual investors and FIs have specific maturity preferences Interest rates are determined by distinct supply and demand conditions within many maturity segments Investors and borrowers deviate from their preferred maturity segment only when adequately compensated to do so A forward rate (f) is an expected rate on a shortterm security that is to be originated at some point in the future The one-year forward rate for any year N in the future is: N N N 1 f [(1 R ) /(1 R ) ] N 1 N

13 Time Value of Money and Interest Rates The time value of money is based on the notion that a dollar received today is worth more than a dollar received at some future date Simple interest: interest earned on an investment is not reinvested Compound interest: interest earned on an investment is reinvested Present Value of a Lump Sum Discount future payments using current interest rates to find the present value (PV) PV = FV t [1/(1 + r)] t = FV t (PVIF r,t ) PV = present value of cash flow FV t = future value of cash flow (lump sum) received in t periods r = interest rate per period t = number of years in investment horizon PVIF r,t = present value interest factor of a lump sum Future Value of a Lump Sum Relation between Interest Rates and Present and Future Values The future value (FV) of a lump sum received at the beginning of an investment horizon FV t = PV (1 + r) t = PV(FVIF r,t ) FVIF r,t = future value interest factor of a lump sum Present Value (PV) Interest Rate Future Value (FV) Interest Rate

14 Present Value of an Annuity Future Value of an Annuity The present value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon t t j 1 (1 i) PV PMT [1/(1 r )] PMT i j 1 PMT = periodic annuity payment PVIFA r,t = present value interest factor of an annuity The future value of a finite series of equal cash flows received on the last day of equal intervals throughout the investment horizon t 1 t j (1 i) 1 FVt PMT (1 r ) PMT i j 0 FVIFA r,t = future value interest factor of an annuity Effective Annual Return Financial Calculators Effective or equivalent annual return (EAR) is the return earned or paid over a 12-month period taking compounding into account EAR = (1 + r per period ) c 1 c = the number of compounding periods per year Setting up a financial calculator Number of digits shown after decimal point Number of compounding periods per year Key inputs/outputs (solve for one of five) N = number of compounding periods I/Y = annual interest rate PV = present value (i.e., current price) PMT = a constant payment every period FV = future value (i.e., future price)