1. Institutions and Markets Economics 71a Spring 2005 Gitman/Joehnk Chapter 2 Lecture notes 3

2. Goals  Financial institutions  Financial markets  Financial transactions

3. Institutions (the players) 1. Commercial banks 2. Mutual funds 3. Pension funds 4. Securities firms 5. Insurance companies 6. Others

4. 1. Commercial Banks  Consumers Deposits/savings Lending/transactions  Consumer loans  Home mortgages  Checking accounts  Credit cards  Debit cards  Foreign exchange  Brokerage (recent)

5. 1. Commercial Banks  Firms Cash management Lines of credit  Loan of varying magnitude  Similar to credit card Bank loans (term loans)

6. 1. Commercial Banks  Intermediary roles Between lenders and borrowers Repackaging financial products  Regulatory environment Key aspect of monetary policy Federal Deposit Insurance Corporation (FDIC) Federal Reserve System

7. 2. Mutual Funds  Function Consumer investments -> Firms  Types Stock (invest in stock market portfolios) Money market (short term lending to firms) Bond Real Estate

8. 2. Mutual Funds  Allow consumers to better diversify  Gather and process investment information  Major industry in Boston

9. 3. Pension Funds  Manage/invest employee savings/pension plans  Similar in spirit to mutual funds  Hired by employer

10. 4. Securities Firms  Investment banks/brokerage firms  Issue stock and bonds (IPO: Initial public offering)  Facilitate trades in securities  Banks versus Investment Banks The repeal of Glass-Steagall (1999)

11. 5. Insurance Companies  Insure individual and corporate risks  Receive payments (insurance premia)  Payout for losses  New issues Trading insurance policies Derivatives High tech risk management

12. 6. Other Institutions  Savings and loans Savings -> home mortgages  Credit unions  Information and software services Bloomberg Quicken Microsoft

13. Goals  Financial institutions  Financial markets  Financial transactions

14. Markets  Primary markets New issues (IPO’s, corporate and public debt)  Secondary markets Trading old stuff In many cases most activity in secondary

15. Money and Capital Markets  Money markets Short term securities (1 year or less)  Capital markets Longer term

16. Money Market Securities  Treasury bills U.S. government debt Short term (less than 1 year)  Commercial paper Short term corporate borrowing  Discount pricing Buy for $10, get paid $11 in future No interest payments

17. Capital Market Securities  Bonds (longer term borrowing) U.S. Treasury Municipal (tax free) Corporate More later

18. Capital Market Securities  Stocks Common stock Preferred stock International More later

19. Primary Market  Initial public offering (IPO)  Initial sale of stock or bond  Late 1990’s boom

20. IPO Timing  Private firm Negotiations between shareholders and other initial investors (Venture Capital) Find investment bank to handle IPO  Prospectus filed with Securities and Exchange Commission  Red Herring : Version of prospectus for initial investors  Quiet period: filing to 1 month after IPO Restrictions on public information releases

21. Investment Banks  Originating investment bank  Underwriting syndicate Insures shares will be purchased  Selling group  How do people get paid? Underwriters pay IPO firm ($15/share) Sell to selling group ($16/share) Sell to investors ($17/share) Scandals and IPO prices

22. Trading and Secondary Markets  Stock markets  Bond markets  Derivatives  Foreign Exchange

23. U.S. Stock Markets  New York Stock Exchange (NYSE)  National Association of Securities Dealers Automated Quotation (Nasdaq) American Stock Exchange (AMEX)

24. Continuous Trading  Market types Specialist Electronic dealer Open outcry Over the counter  NASDAQ  Upstairs (negotiated)  ECN (electronic crossing network)

25. ECN’s: Electronic Crossing Networks  Internet based trade networks  Customers can meet directly (no broker)  Used mostly by professional money managers  Advantage: fewer intermediaries  Disadvantage: less liquidity (Fewer people to trade with)  Fastest growing markets

26. Other Markets  Futures/Options  Foreign Exchange Spot versus forward  Bond

27. International Markets  Many major international stock markets London Tokyo China many more  US accounts for only 36% of the companies listed on stock markets around the world

28. Why Should U.S Investors Care?  Diversification  Performance  Industries

29. How Can U.S. Investors Invest Globally?  Multinational firms Microsoft Ford  Mutual funds  Direct purchases US securities/foreign firms (Yankee Bonds) American deposit receipts (ADR’s) WEBS (World Equity Benchmarks)

30. International Risks  Macroeconomic risks  Political risks  Exchange rate risks

31. Trading Hours  Most U.S. stock markets 9:30-4:00  Extended hours on electronic trading networks  “After hours trading”  International markets (local times)  Foreign exchange markets (24 hours)  Hours increasing : toward a 24 hour market

32. Market Regulation  Securities laws protect investors Federal and state laws  Securities and exchange commission (SEC): established in 1934  Important laws Securities act of 1933 (IPO rules) Insider trading and fraud act of 1988 Sarbanes-Oxley act of 2002  Tighter controls on accounting information

33. Goals  Financial institutions  Financial markets  Financial transactions

34. Long Purchase  Straight purchase of a security  Speculate that price will increase Buy at 100 Sell at 110 10% return

35. Margin Purchase  “Buying on margin”  Borrow money to buy stock  Buy at 75% margin 75% of money in investment is yours 25% is borrowed from broker or bank  Purchase $100 of stock at 75% margin You put in $75, and you borrow $25

36. Basic Margin Formula

37. Margins and Magnification  Example stock: Price = $100 Up: Price = $150 Down: Price = $75  If you purchased with your own money $100 total investment Up: + $50 Down: - $25

38. Margins and Magnification  Buy on 50% margin (zero interest charges)  $100 own, and $100 borrowed (needs to be paid back)  Purchase $200/$100 shares = 2 shares $100 total investment Up: 2*150 - 100 - 100 = $100 (50) Down: 2*75 - 100 - 100 = $-50 (-25)

39. Margin Buying  Borrowing money to buy stocks  Magnifies gains and losses  Can lose more than you put in Buy $200 of stock  $100 your own  $100 borrowed Stock goes to zero  Lose $100 of own investment, and  Owe $100 of borrowed money too

40. Maintenance Margins  Margin required for investor to maintain  If margin falls below this level investors must add more of their own money  “Margin call”  Common margin call Prices fall Margin rises Investor needs to come up with more funds

41. Margin Requirements  Common stock: 50%  Bonds: 50%  Options: 20% stock value  Futures: 2-10% of the contract value

42. Short Sales  Holding negative stock Sell stock you don’t have (borrow) Buy it back later Pay dividends yourself in between  Key issue Make money on a price fall Lose money on a rise  Betting against a stock

43. The Mechanics of a Short  Tell broker you want to sell 100 shares of IBM short (price = $50)  Broker “borrows” shares of 100 shares of IBM owned by another client  Sells it to someone for 50*100=5000, and pays this to you  You must keep this amount on account with broker  When dividends are to be paid, you pay broker, and broker pays the other client

44. The Mechanics of a Short  IBM goes down to $40 per share  You “buy” your 100 shares to take you back to zero, pay broker 40*100=4000.  Broker buys at market, and puts the shares back in the other person’s account  You make 5000-4000 = 1000 (less dividends)  Make money when price falls  Lose money when price rises

45. The Mechanics of a Short  IBM goes up to $60 per share  You “buy” your 100 shares to take you back to zero, pay broker 60*100=6000.  Broker buys at market, and puts the shares back in the other person’s account  You lose 5000-6000 = -1000 (less dividends)

46. Margins and Shorts  Broker requires additional funds to cover possible losses  Fraction of additional sale amount  Example Sell $5000 worth of stock at 60% margin Need to keep 0.6*5000 = 3000 on account with the broker Maintain fraction of value of the stock in this account When the price goes up, need to increase this “Margin call”

47. Oddities About Shorts  Can lose unbounded amounts of money Normally only lose what you put in With short price can go up forever, and your losses keep increasing  Also, broker can get in trouble if you default Other customer could lose original shares Often insured for this

48. Short Interest  Fraction of shares sold short  Measure of market pessimism in a stock  Common market indicator  Measures market pessimism

49. Squeeze Play  Assume Microsoft has a large number of short sellers  Price starts to rise Short sellers losing money Get nervous Buy stock to close out their short positions Prices rise more, more buying.. (etc. etc)

50. Goals  Financial institutions  Financial markets  Financial transactions