Chapter 1 Introduction

Types of Assets zTangible Assets yValue is based on physical properties yExamples include buildings, land, machinery zIntangible Assets yClaim to future income generated (ultimately) by tangible asset(s) yExamples include financial assets

Types of Financial Assets zBank loans zGovernment bonds zCorporate bonds zMunicipal bonds zForeign bond z Common stock z Preferred stock z Foreign stock

Debt vs. Equity zDebt Instruments yFixed dollar payments (‘fixed income’) yExamples include loans, bonds zEquity Claims yDollar payment is based on earnings yResidual (varying) claims yExamples include common stock, partnership share

Price of Financial Asset and Risk zThe price or value of a financial asset is equal to the present value of all expected future cash flows. yExpected rate of return yRisk of expected cash flow

Types of Investment Risks zPurchasing power risk = inflation risk zDefault risk = credit risk (special case of PP risk) zExchange rate risk = currency risk

Role of Financial Assets zTransfer funds from those with more money than projects to those with more projects than money. zShare unavoidable risk associated with cash flows. yEquity holders bear inflation risk yDebt holders bear default risk yBoth may bear exchange rate risk

Role of (Financial) Markets zProvide liquidity: buyers and sellers all in one ‘place’. zprice discovery  efficient resource allocation zReduce transactions costs: ysearch costs yinformation costs (market efficiency)

Classification of Financial Markets zNature of asset: debt vs. equity markets zMaturity: money (short) vs. capital (long) markets zSeasoning: primary vs. secondary markets zDelivery: cash (= spot) vs. derivatives markets zStructure: auction vs. over-the-counter (OTC) vs. intermediated markets

Financial Market Participants zHouseholds zBusiness units zFederal, state, and local governments zGovernment agencies zSupranationals (= multilaterals) zRegulators (broader definition)

Globalization of Financial Markets zIn general, easier for investors to move capital internationally zCauses: yDeregulation (liberalization) of financial markets (e.g. currency controls) yTechnological advances yIncreased role of institutional investors (economies of scale), inc. CalPERS

Classification of Global Financial Markets Internal Market (= national market) External Market (= international, offshore or Euromarket): securities offered outside single jurisdiction to investors in multiple countries Domestic Market: issuers domiciled in the country Foreign Market: issuers domiciled abroad

Motivation for Using Foreign Markets and Euromarkets zLimited fund availability in internal market (esp. in poorer countries) zReduced cost of funds zDiversifying funding sources (portfolio reduces risk)

Derivatives Market zDerivatives’ value depends on underlying (financial) asset zFutures/forward contracts: parties agree to buy/sell at an agreed price and date. zOptions contracts: rights (not obligations) to buy (call) or sell (put) at an agreed price on/by an agreed date.

Role of Derivative Instruments zBuy/sell risk (e.g. purchasing power risk, interest rate risk, exchange rate risk) z`Zero sum’ zHowever, there are still advantages: yMay be lower transactions costs yCan be faster to transact than cash market yGreater liquidity yAllows great scope for financial innovation…

Chapter 2 Financial Intermediaries and Financial Innovation

Services of Financial Institutions zFinancial intermediaries transform financial assets (then their liabilities): inc. deposits, insurance, pensions zHelp create, launch financial assets (underwriter) zTrade financial assets for customers (broker) zTrade their own financial assets (dealer) zProvide investment advice

Role of Financial Intermediaries zObtain funds (their liabilities, e.g. deposits) & invest them (their assets, e.g. loans): transfer funds from savers to investors zDirect investment ye.g. bank buys corporate stocks or bonds zIndirect investment ye.g. individual deposits money in a bank that buys…

Intermediaries and asset transformation zMaturity intermediation yMany short term deposits = a long term loan yLonger loan terms usually more expensive zReducing risk by diversification yportfolio, covariance, marriage [?] zSpecialization reduces costs: contracting and information processing, etc. zEnable non-cash payments (cheques, plastic)

Asset/Liability Management zSpread and Non-Spread Businesses ybuy/bid v. sell/ask spread (inc. insurance) ynon-spread: fund management fees zNature of Liabilities ycontracts specify amount, timing of payment ysee chart on next page zLiquidity: redeeming liabilities prematurely zRegulations and taxation

Nature of Liabilities of Financial Institutions

Categories of Financial Innovation (Economic Council of Canada) zMarket-broadening instruments yattract new investors zRisk-management instruments yre-allocate risk zArbitraging instruments and processes yfacilitate arbitrage

Categories of Financial Innovation (BIS) zPrice-risk-transferring innovations yfor price/exchange rate risk zCredit-risk-transferring instruments zLiquidity-generating innovations yinc. by avoiding regulatory constraints zCredit-generating instruments (debt funds) zEquity-generating instruments (capital base)

Causes of Financial Innovation zFinancial innovation is a form of innovation zReasons to innovate: yimprove products (e.g. cut costs, including taxes – v. ‘Rules in OECD Countries to Prevent Avoidance of Corporate Income Tax’, Thuronyi) ydifferentiate products zExplosion in financial products since 1980s: ytheoretical developments (e.g. Black-Scholes)  more sophisticated market participants ytechnical developments: computers, IT yderegulation  greater competition by intermediaries yincreased risk [?]: see chart on next page zChanging global patterns of financial wealth

Increased volatility? St Louis Fed: FRED II

Asset Securitization zSecuritization: y“homogenizing and packaging financial instruments into a new fungible [interchangeable] one” (Barkley International Inc.) zMany institutions instead of a single one: ybank A makes home mortgages ybank A hires bank B to issue securities backed by the mortgages ybank A buys credit risk insurance ybank A sells loan servicing right

Benefits to Issuers zSpecialization/out-source to focus on ‘core competences’: service fees (to collect & forward payments…)? zDiversification reduces risks, hence costs zManage risk-based capital requirements zManage interest rate volatility

Other Benefits zTo Investors (buyers of securities) ygreater liquidity yreduced credit risk zTo Borrowers ylower lending rate spreads zSocial Benefits ye.g. `viatical settlement’: trade life insurance benefits