1. 01.24.2001Lecture Notes Finance 3191 Finance 319 Lecture 5 & the beginning of Lecture 6 Course Website http://www.citi.umich/u/galka/319 u Galina Albert Schwartz Galina Albert Schwartz u Department of Finance u University of Michigan University of Michigan u Business School Business School

2. 01.24.2001Lecture Notes Finance 3192 Practical Matters: Investment History Video On Wed, 01.31.2001 7:00pm, room - D1230 How The Really Smart Money Invests: A Brief History of Investing

3. 01.24.2001Lecture Notes Finance 3193 A Summary: Market Structure & Institutions u Readings: Levich, Chapters 2 & 3 u Volume of foreign exchange market: 60 times world trade, [which is 10 - 20 times world GDP]. Why? u Foreign Exchange Market Structure, p. 83 - 85 u Is this market a zero-sum game?

4. 01.24.2001Lecture Notes Finance 3194 Financial Institutions u Two types of Financial Institutions –1. commercial banks –2. investment banks [US: illegal to do 1 & 2 simultaneously] u Functions of Banks –Intermediation –Liquidity provision services –Risk management

5. 01.24.2001Lecture Notes Finance 3195 A Brief on Bank Regulation u Regulatory Environment [history] –FED (Federal Reserve System) (Act of 1913) »Reserve requirements were fixed by Federal Reserve Act »FED controls the economy through u money supply & u discount loans to member banks

6. 01.24.2001Lecture Notes Finance 3196 A Brief on Bank Regulation (cont.) –Glass-Steagall Act (1933): »Limits the competition between banks (makes them less likely to fail) »Separates banking and securities [1 & 2, see above] »Establishes Federal Deposit Insurance Corporation (FDIC) »G-S: prohibits interest bearing checking »Limits the interest paid on time deposits

7. 01.24.2001Lecture Notes Finance 3197 A Brief on Bank Regulation (cont.) u Regulation Q (until 1986 a ceiling interest rate on saving deposits): (Req. Q is likely to be abolished) u Regulation Z (the “truth in lending” regulation) –Lender must disclose a total interest cost of the credit u The reasons for these regulations?

8. 01.24.2001Lecture Notes Finance 3198 Debt Classification & Asset Liquidity u Debt classification: –Short term < 1 year –Medium term 1 year to 10 years maturity –Long term >10 years u Liquidity of an asset: relative ease & speed to be converted into the medium of exchange

9. 01.24.2001Lecture Notes Finance 3199 Classification of Securities u Money Market Securities: –Short-term, low risk, very liquid u Capital Market Securities (for example, mortgages) –long term, highly risky & of limited liquidity: the features are opposite to Money Market Securities

10. 01.24.2001Lecture Notes Finance 31910 Foreign Exchange Market Structure (Figure 3.4) u Transactions of two types: 1. through Direct Dealing or 2. through a broker u 1. Direct Dealing is direct phone contact with another bank dealer –advantage – information from the way the dealer “shades the price ” u Dealers are market makers (p. 81), the role of dealers’ trades is – to acquire and lay risks & – to discover transaction prices

11. 01.24.2001Lecture Notes Finance 31911 Foreign Exchange Market Structure (cont.) u 2. Brokers are intermediaries who reduce search costs –advantage – lower price through shopping around, –disadvantage – commission to pay u Reuters Dealing 2000-1 up to 4 dealers’ quotes on the same screen (still far from a worldwide polling)

12. 01.24.2001Lecture Notes Finance 31912 Contracts u Spot contract – a binding commitment for exchange of funds with normal settlement and delivery in two business days (in case of North American Currencies – in one day) u Forward contract – a binding commitment TODAY about exchange of funds at the pre-specified future date.

13. 01.24.2001Lecture Notes Finance 31913 Types of Trading Activities: u Speculation & Arbitrage –Speculation – when individual’s expectations differ from the market ones –Arbitrage – almost simultaneous (or nearly) purchase of securities in one market for sale in another [in expectation of a risk free profit]

14. 01.24.2001Lecture Notes Finance 31914 Risks in Foreign Exchange Trading, Levich, p. 91 I. Exchange rate & II. Interest rate risks III. credit & IV. delivery risks u I. Exchange rate risk addressed by –placing the limits on the size of open currency positions u II. Interest rate risk addressed by –placing the limits on the size of open forward positions

15. 01.24.2001Lecture Notes Finance 31915 Risks in Foreign Exchange Trading, (cont.) I u III. Credit risk addressed by: – diversification, – placing maturity limits on each customer & –limiting their positions u IV. Delivery risk addressed by –spreading delivery time dates [Risk associated with delivery of a contract across the time zones (because the two transaction legs are NOT simultaneous)]

16. 01.24.2001Lecture Notes Finance 31916 Aggregate Statistical Facts u Annual volume of foreign exchange market is about 10 - 20 times of world Gross National Product (GDP). Why??? u  90% of spot trades are between financial institutions (i.e. investment banks and securities firms) u 2/3 are cross-border  serious concerns about counterparty risks and clearing and settlement arrangements.

17. 01.24.2001Lecture Notes Finance 31917 Bank for International Settlements (BIS) u settlement risk is –due to weak (or high cost) legal system –important in international contracts [because international law is poorly enforceable] u BIS (1996) report: urges banks & central banks –to cooperate [to reduce exposure to settlement risk]

18. 01.24.2001Lecture Notes Finance 31918 Risks in Foreign Exchange Trading, (cont.) II u 1. Counterparty risk is the risk of default on the terms or conditions of the contract u 2. Clearing risk & u 3. Settlement risk 1, 2 & 3 are related u All buyers & sellers have the same counterparty –a clearinghouse. This standardizes the clearing risk [to a certain extent]

19. 01.24.2001Lecture Notes Finance 31919 Explaining Aggregate Facts Positive Investment Banks’ Profits u Since profits are positive  the game is not a zero-sum game u Why aggregate foreign exchange market is not a zero-sum game? Financial institutions: –hold the risks (instruments: forwards, swaps) –provide intermediation (spot) –provide information –provide facilities (`physical infrastructure’)

20. 01.24.2001Lecture Notes Finance 31920 Explaining Aggregate Facts Why Trading Volume Is That High? u To provide 1 - 4 (i.e. international financial infrastructure) one has to trade a lot, (which explains a very high volume of foreign exchange market transactions). u This high volume is an `intermediate good’, which permits to accomplish 1 - 4. u  90% of this volume are inter bank trades, which is consistent with the `intermediate good’ explanation

21. 01.24.2001Lecture Notes Finance 31921 Next Lecture: Purchasing Power Parity u Purchasing Power Parity = PPP u To read: Levich, Ch. 4 u Rogoff, Kenneth, (1996), “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, Vol. 34, No. 2., pp. 647-668. (S)

22. 01.24.2001Lecture Notes Finance 31922 Summary of Today u Terminology & Market Structure u Is foreign exchange market a zero- sum game? [NO] u Banks have positive profits due to infrastructure provision