1. 1 Chapter 2: The Financial System Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley Objective Understanding the workings of the financial system Determining rates of return

2. 2 Chapter 2 Contents 1 What is a Financial System1 What is a Financial System 2 The Flow of Funds2 The Flow of Funds 3 The Functional Perspective3 The Functional Perspective 4 Financial Innovation & the “Invisible Hand”4 Financial Innovation & the “Invisible Hand” 5 Financial Markets5 Financial Markets 6 Financial Market Rates6 Financial Market Rates 7 Financial Intermediaries 8 Financial Infrastructure and Regulation 9 Governmental & Quasi- Governmental Organizations

3. 3 The Financial System Financial decisions are made within the context of a financial system The financial system both constrains and enables the decision maker This chapter provides a framework for understanding how financial systems work

4. 4 2.1 What is the Financial System? A Financial System is comprised of – –markets, intermediaries, service firms and other institutions used to carry out the financial decisions of households, business firms, and governments

5. 5 Geography of the Markets – –some markets for a particular market instrument may have a well defined geographic location such as the New York Stock Exchange or the Osaka Options and Futures Exchange – –other market instruments are traded on over-the-counter or off-exchange markets for bonds, stocks, and foreign exchange

6. 6 Contractual Jurisdictions The jurisdiction governing a trade needs to be clearly established before making significant investments, particularly when trading over a computer network Jurisdictional conflicts are too frequent, and have significant economic consequences because legal principles vary significantly between jurisdictions

7. 7 2.2 The Flow of Funds –Funds may flow from the surplus unit to the deficit unit DirectlyDirectly Through marketsThrough markets Through intermediariesThrough intermediaries

8. 8 Financial Intermediary – –a firm whose primary business is to provide financial services and financial products – –Examples: bank (checking accounts, loans, CDs …) investment company (mutual funds …) insurance company (term life insurance …)

9. 9 The Flow of Funds Diagram Markets Intermediaries Surplus UnitsDeficit Units

10. 10 The Flow of Funds Diagram We shall examine various pathways from the surplus unit to the deficit unit

11. 11 Fund Flows via Market A household with surplus funds invests them in government bonds

12. 12 Fund Flows via Market Markets Intermediaries Surplus UnitsDeficit Units

13. 13 Fund Flows via Intermediary Holders of surplus funds may use an intermediary, such as a bank, to invest them. The bank receives the surplus funds, say as 90-day deposits, and adds them to the bank’s assets (creating a bank liability). Money is fungible, so the corresponding loan can not be identified

14. 14 Fund Flows via Intermediary Markets Intermediaries Surplus UnitsDeficit Units

15. 15 Fund Flows via Intermediary and Market Sometimes the intermediary itself has surplus funds, and invests them in the market or another intermediary A bank that borrows and invests in the money market can increase its flexibility, reduce its risks, and turn a profit Eventually, the surplus funds are consumed by a deficit unit

16. 16 Fund Flows via Intermediary and Market Markets Intermediaries Surplus UnitsDeficit Units

17. 17 Fund Flow via Markets and Intermediaries Intermediaries such as General Motors Acceptance Corporation issue commercial paper to finance car loans and leases made to households needing a car In this case, the paper has a shorter maturity than the loan, leading to a risk

18. 18 Funds Flow via Markets and Intermediaries Markets Intermediaries Surplus UnitsDeficit Units

19. 19 Funds Flow: Disintermediation Sometimes the cost of using markets and intermediaries cannot be justified, and surplus units and deficit units contract directly at its discretion, the deficit unit may repurchase contracts before their maturity, (at a proper discount), to avoid disrupting secondary markets, and to add liquidity

20. 20 Funds Flow: Disintermediation Markets Intermediaries Surplus UnitsDeficit Units Markets Intermediaries Surplus UnitsDeficit Units

21. 21 Funds Flow: Secured Credit Poor credit risks sometimes receive credit card applications from banks offering a $1,000 credit limit, if $1,000 is deposited into a savings account as collateral 19.56% is charged on the card balance, while 3.5% is paid on deposits. A high annual fee is also charged

22. 22 Funds Flow: Secured Credit Markets Intermediaries Surplus UnitsDeficit Units Poor Credit Risk

23. 23 2.3 Functional Perspective – –A U.S. banks today differs from a 1928 U.S. bank, and a Saudi bank today. A credit union in the U.S. today shares many of the same functions as a U.S. bank – –Analyzing institutions from a functional perspective helps us to understand why institutions differ over time and jurisdiction

24. 24 Six Key Financial Functions: – –Transferring Resources Across Time & Space – –Managing Risk – –Clearing and Settling Payments – –Pooling Resources and Subdividing Shares – –Providing Information – –Dealing with Incentive Problems

25. 25 Transferring Resources Across Time and Space A financial system provides ways to transfer economic resources through time, across geographic regions, and amongst industries

26. 26 Transferring Resources Across Time and Space (Illustration) – –A Dutch household currently has excess funds needed in ten years – –A Chinese business would become more profitable with new investment funds Financial markets make this match

27. 27 Managing Risk A financial system provides ways to manage Risk

28. 28 Managing Risk Future flows have associated risks. Like flows, risks may be unbundle and repackaged by a financial system using portfolios, financial derivatives, and guarantees Many financial contracts target risks rather than flows

29. 29 Managing Risk A fund manager may increases risk (and expected returns) of a fund by issuing bonds secured against the funds assets, writing put options, buying call options, and going “long” market index futures Another fund manager may decrease risk by investing in the money market, put options, and short index futures

30. 30 Clearing and Settling Payments A financial system provides ways of clearing and settling payments to facilitate the exchange of goods, services, and assets

31. 31 Clearing and Settling Payments Barter (Levi jeans, old stamps & coins) Gold (requires purity assay, heavy) Paper money (restricted geographically) Credit cards (not universally accepted) Personal, cashier's or traveler’s checks (acceptability varies, denomination)

32. 32 Pooling Resources and Dividing Ownership in Large Assets A financial system provides a mechanism for the pooling of funds to undertake large-scale indivisible enterprise or for the subdividing of shares in large enterprises with many owners

33. 33 Pooling Resources and Dividing Ownership in Large Assets T-bills have a minimum face value of $10,000, but have very low risk (Solution: money market mutual fund) Developing a promising technology would expose a single firm to too much capital risk (Solution: joint venture) A household wishes to divest itself of its ownership in a chain of restaurants (Solution: Form a corporation, and sell its stock

34. 34 Providing Information A financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy

35. 35 Providing Information Investors need current prices to evaluate their portfolios of quoted securities Quoted prices may be used to estimate the value of similar non-quoted securities Option prices may be used to determine the market’s assessment of a stock’s risk

36. 36 Family Loans: Advantages Favorable information about you that’s available to your family may not be available to commercial lenders This aberration leads to an opportunity – –You may be able to obtain a family loan at a lower interest rate – –Your family member may make a higher return on a similar risk

37. 37 Family Loans: Disadvantages Family loans tend to be harder to collect, because collection may threaten family ties Family members are often naive when evaluating the credit risk of loved ones Commercially available investments are liquid, and offer more appropriate cash flows and risk-reward tradeoffs The family lender is exposed to individual risk that is diversified away (without significant cost) in a commercial investment

38. 38 Dealing with Incentive Problems A financial system provides ways to deal with the incentive problems that occur when one party to a financial transaction has information that the other party does not, or when one party is an agent and makes decisions for another

39. 39 Moral-Hazard – –Adam enters into an insurance contract with Carmel. Adam pays Carmel a premium of $10,000. Camel will reimburse Adam’s costs should a fire damage his business during the next year, but pay nothing otherwise. Adam believes he can reduce the probability of fire by installing a cheap sprinkler. Without the contract he would certainly install the unit, but he gains nothing by installing the unit with the insurance contract in force. – –Adam is exposed to a moral hazard. Adam is now taking less care of his assets now that Carmel has assumed the risk of their loss

40. 40 Adverse Selection – –Carmel has identified 100 businesses that fall into the category of having a flood on average once every 200-years. Based on this estimate, Carmel sets a premium based on 1% of the insured amount. – –Adam’s business is one of the 100, and he accepts the contract believing that his business premises are subject to flood about every 50-years. – –Dillip’s business is another of the 100, but he does not accept the contract because he believes that there is almost no chance of flood damaging his business

41. 41 Principal-Agent Problems – –Adam is the real-estate agent marketing Carmel’s house that’s worth $200,000 for a 6% commission – –Adam’s agency has a multiple-listing agreement with other agencies, whereby listing agents receive 2.5%, and selling agents receive 3.5% – –Bernadette wishes to buy the home for only 90% of its market value, $180,000. – –Adam urges Carmel to accept the offer. Why? the agency will receive only $5,000 if it is sold by another agency at full value the agency makes $10,800 if Adam can persuade Carmel to sell at the lower price

42. 42 Insure and Burn A business has a warehouse full of unfashionable clothes The owner arranges for insurance at above true market value for the warehouse, its content, and loss of business A fire is then set to collect the insurance

43. 43 Insure and Burn: Solutions Moral risk increases with [market value - insured value], so: – –understand the business of insured companies – –insist the insured assumes some risk of loss – –avoid “unlucky” owners with dubious morality – –gain a reputation for aggressive forensic investigations – –require the use of modern surveillance, detection and protective equipment

44. 44 Insure and Burn: Consequences Insurance becomes over-priced, given the risks, leading to reduced use Insurance companies are exposed to more claims during recessions The economy loses assets that it would have had A barrier to entry is created for new (honest) businesses that lack a claims track-record Increased administrative costs Longer verification delays when settling claims

45. 45 Small Business As a small business owner, your level of effort may depend on the source of borrowing – –If money was borrowed from a friend, rather than a bank, you may work harder. It is hard to let down a friend – –If the money was borrowed from a bank, rather than a friend, you may work harder. Banks are less forgiving than friends If your behavior depends upon the source of a loan, then you are the victim of moral hazard

46. 46 Adverse Selection You have a pain in your chest, obtain life insurance, and then visit your doctor The insurance company has fraudulently assumed a high risk Knowing that you will die soon, you won’t now purchase that life annuity, leading to a non-fraudulent adverse selection Asymmetrical information has resulted in adverse selection Insurance companies adjust their premiums for adverse selection

47. 47 Adverse Selection Some insurance companies exploit rules designed to protect them against fraudulent adverse selection – –You visit the doctor with the usual spectrum of medical complaints, the doctor takes notes, and neither of you are concerned – –You obtain $1,000,000 in life insurance in good faith – –Later, a car mounts the sidewalk, killing you – –The insurance company refuses to pay your estate, claiming a preexisting condition found in your records that would have caused them to refuse the risk

48. 48 Principal-Agent Problem Your are still dead. Your spouse dials: 1-555-SUE-THEM, and agrees to the lawyer’s 33.33% contingency The insurance company offers to settle the $1,000,000 claim for $300,000 – –Acceptance of the offer earns the lawyer a risk-less $100,000 for two hours work – –Rejecting the offer leads to higher risk and expected reward, but at the expense of considerable trial preparation The lawyer advises her vulnerable client to settle Some insurance companies “size” their settlement to be attractive primarily to the lawyer, who will then “sell” it to their client

49. 49 Principal-Agent Examples An employee selects an airline, hotel or car rental company to obtain free flight mileage for personal use – –The decision has been made in interest of the employee, rather than the company – –The company may lose time, or pay a higher price for service

50. 50 Principal-Agent Examples A supplier gives gifts to its customers’ employees having influence over purchase decisions Traditionally, these gifts include Caribbean sweepstakes, gift vouchers, entertainment, and outright bribes The supplier is attempting to subvert employee loyalty by creating an principal-agent conflict – –In some industries there is a tradition, tolerated by higher management, of accepting “adult entertainment” from suppliers – –In addition to perpetuating an principal-agent conflict, both companies expose themselves to large sexual discrimination suits from female buyers and salespeople

51. 51 2.4 Financial Innovation & the “Invisible Hand” Financial innovation occurs spontaneously from the individual actions of entrepreneurs and firms, and not from the actions of a central authority. Example: Credit cards

52. 52 2.5 Financial Markets: By Basic Financial Assets Debt (Also called fixed income securities, Bonds and Loans) Fixed Income Instruments promising fixed future payments Equities (Common Stock/Shares) Residual claim on assets. Limited liability Derivatives (Options, Forwards, Futures) Securities that derive their value from other securities

53. 53 Markets: By Maturity Money Market – –Mostly debt instruments issued by governments and secure large corporations – –Highly liquid: Quickly convertible to cash – –Globally integrated Capital Market – –Equities, and debt instruments with a life greater than a year

54. 54 2.6 Financial Market Rates Interest rates Exchange rates Stock-market indicators

55. 55 Financial Market Rates Interest Rates – –The Promised rate of return. Examples: Mortgage rate Commercial Rate – –Depend upon: Unit of account Maturity Default Risk

56. 56 Unit of Account The medium in which the payments are denominated – –Usually a currency, but may be a commodity such as gold, silver, a standard “basket” of goods and services

57. 57 Exchange-Rate Risk on T-Bills A bond issued by a central government is risk-free only in that country – –The bond’s return in a foreign investor’s currency is uncertain because exchange rates fluctuate, and future cash flows are denominated in the domestic country’s unit of account

58. 58 Other Risks on T-Bills T-Bills are default-free, but not risk-less You observe that the 12-month T-Bill has a higher yield than the 6-month T-Bill. You plan to take advantage of this by buying a T-Bill with a maturity of 12 months, and plan to sell it after 6 months to pay college fees. Interest rate fluctuations result in a slightly higher (or lower) than expected capital return Occasionally, the 3-month rate may be higher than the 6- month rate, but rolling-over a 3-month bill results in risk, too Even a 6-month bill is not risk-less to you if inflation is uncertain. This college may increase fees by 20%

59. 59 Example: Exchange Rate Risk Suppose: – –You are a Japanese Investor wishing to make a 1-year investment – –Current exchange rate (Spot) of 150 Japanese yen/pound sterling – –Japanese bonds yield 3% – –British bonds yield 9% – –Investment 15,000 ¥ – –Crystal ball: Spot 1-year from now 140 ¥/£

60. 60 Exchange Rate Example 15000 ¥ 15260 ¥ 15450 ¥ £100 £109 Time 3% ¥/¥ (direct) 1.73% ¥/£/£/¥ 150 ¥/£ 9%£/£ 140 ¥/£ JapanU.K.

61. 61 Exchange Rate Example The currency speculation doesn’t pay-off under this scenario. It returns only 1.73%, which is below the 3% offered by a direct Japanese investment – –A new crystal ball indicates that the correct exchange rate one-year from now is not 140, but 149, Yen per Pound Observe that the currency speculation does pay-off under this scenario. It returns 8.27%, which is above the 3% offered by a direct investment

62. 62 Exchange Rate Example 15000 ¥ 16241 ¥ 15450 ¥ £100 £109 Time 3% ¥/¥ (direct) 8.27% ¥/£/£/¥ 150 ¥/£ 9%£/£ 149 ¥/£ JapanU.K.

63. 63 Exchange Rate Example Our Japanese speculator now sees a business opportunity She will offer financially sound Japanese companies doing business in London a contract that obligates both herself and them to buy or sell pounds for Yen at a fixed exchange rate one year from now

64. 64 Exchange Rate Example Her idea is to issue, or purchase, risk- free 1-year bonds (She has a superb credit rating) in Yen, and invest the proceeds in 1-year British bonds Doing this she is creating a derivative security that she calls a Forward Exchange Rate Contract

65. 65 Exchange Rate Example 15000 ¥ (borrowed) 15450 ¥ Repaid £100 Invested £109 Matures Time 3% ¥/¥ (direct) 3% ¥/£/£/¥ 150 ¥/£ 9%£/£ Forward ¥/£ JapanU.K.

66. 66 Exchange Rate Example Note: This is for 1 year, but the analysis is easy to generalize

67. 67 Maturity The maturity of a fixed-income instrument is the date of, or period to, its final cash flow – –The interest rate on short-term instruments may be higher, lower or the same as long- term instruments

68. 68

69. 69 Default Risk The possibility that some portion of the interest or the principal on a fixed- income security will not be paid in full – –The greater the perceived default risk, the higher the interest rate the issuer must promise to give – –Yield Spread (See next Table)

70. 70 Yield Comparisons

71. 71 Financial Market Rates Rates of Return on Risky Assets – –Many assets do not promise a rate of return Real Estate Equity Securities Works of Art – –Return comes from: Any Cash Flows from the Asset Capital Gains

72. 72 Holding Period Return Assume: – –Purchase price of Share was $100 – –Selling price 1-year later was $105 – –Cash dividends paid in year were $5

73. 73 Computation of Return

74. 74 Financial Market Rates Market Indexes and Market Indexing – –Overall level of stock prices, A benchmark US: DJI, SP500 Japan: Nikkei, Topix UK: FT-30, FT-100 Germany: DAX France: CAC 40 Switzerland: Credit Suisse Europe, Australia, Far East: MSCI, EAFE

75. 75 Financial Market Rates Rates of Return in Historical Perspective – –The following graphs show the returns of selected securities and inflation The first shows annual returns The second shows affects on $1 invested in 1925. The scale is logarithmic in order to show all the graphs on the same chart

76. 76

77. 77

78. 78

79. 79 Financial Market Rates Inflation and Real Interest Rates – –Nominal Prices & Rates Prices and rates expressed in terms of currency – –Real Prices & Rates Prices and rates expressed in terms of purchasing power

80. 80 Nominal to Real

81. 81 Financial Market Rates Interest Rate Equalization – –Interest Rate Arbitrage

82. 82 Financial Market Rates The Fundamental Determinates of Rates of Return – –Expected Productivity of Capital Goods – –Capital Goods Productivity Uncertainty – –Time Preferences of People – –Risk Aversion

83. 83 Banks (Commercial) Traditional Role: – –Clearing and settling payment Contemporary Role: – –Take Deposits – –Make Loans Limited by the Glass Steagall Act, 1933, from acting as an investment bank

84. 84 Other Depository Savings Institutions Depository savings institutions, thrift institutions: – –Savings Banks – –Savings and Loans Associations – –Credit Unions Compete with Commercial Banks

85. 85 Insurance Companies Purpose is to shed specific risks – –Property and Causality Insurance – –Health and Disability Insurance – –Life Insurance Payments are Called Premiums, and these are invested in real estate, Stock and bonds

86. 86 Pension and Retirement Funds Defined-Contribution Pension Plan Defined-Benefit Pension Plan

87. 87 Mutual Funds A portfolio of stocks, bonds, or other assets purchased in the name of a group of investors, and managed by a professional investment company or financial association Open ended – –Closed ended

88. 88 Investment Banks Assist businesses and governments raise funds by issuing securities Facilitate mergers and acquisitions Underwrite security issues See: Commercial Banks, Glass Steagall Act, 1933

89. 89 Venture Capital Firms Similar to investment banks, but corporate clientele are usually start-up companies Help manage company until ready to go public

90. 90 Asset / Investment Management Firms Advise, and often administer: mutual funds, pension funds, and other asset pools on behalf of individuals, firms, and governments

91. 91 Information Services Firms that specialize in providing financial information – –Standard and Poor’s; Moody’s – –Best (Insurance) – –Bloomberg; Reuters – –Lipper, Morningstar, SEI

92. 92 2.8 Financial Infrastructure and Regulation Rules for Trading Accounting Systems

93. 93 2.9 Government and Quasi- Government Organizations Central Banks Special Purpose Intermediaries Regional and World Organizations