FNCE 3020 Financial Markets and Institutions Fall Semester 2005

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FNCE 3020Financial Markets and Institutions
Fall Semester 2005

• Professor Michael Palmer
• Professor of Finance
• University of Colorado at Boulder
• Fall Semester 2005
• Lecture 1 Introduction and Basic Concepts

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What is your current understanding of financial
markets?

• What is the current U.S. long term corporate bond
  rate?
• What has the Federal Reserve been doing to the
  fed funds rate since the beginning of the year?
• What is the current fed funds rate?
• Which is bigger, the U.S. stock market or the
  U.S. bond market?
• How many stock are in the Dow Jones Industrial
  Average and what is its approximate level?
• The largest foreign exchange market is located in
  what city?
• New York, Tokyo, London
• Who is Alan Greenspan? Who is John Snow?
• How many times a year does the Federal Open
  Market Committee meet?
• Does Cuba have interest rates?

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Important Definitions

• Financial Markets
• Markets through which entities with surplus
  financial funds transfer those surplus funds to
  entities who have a shortage of available funds.
• Financial Institutions
• Entities that facilitate and manage the movement
  of funds from surplus entities to final
  borrowers.

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Functions of Financial Markets

• Mechanism for raising funds!
• Primary financial markets (e.g., IPOs)
• Mechanism for converting financial assets into
  cash before maturity.
• Secondary financial markets (e.g., NYSE)
• Mechanism for generating a return on surplus
  funds.
• Retirement

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Functions of Financial Markets

• Allocates financial resources among
• competing users.
• If done so in the most efficient manner (i.e., to
  the most productive users),
• The process will improve economic efficiency and
• Result in highest possible economic growth!
• Provides financial signals to market participants
• Interest rates, stock prices, exchange rates!
• Tells us something about individual entities
• Tells us something about global perceptions

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Characteristics of a Well Functioning (Efficient)
Financial Market

• Market Transparency
• All participants need to have access to important
  information at the same time.
• Cannot have insider trading opportunities.
• Importance of trading platforms.
• How quickly is trading information made
  available?
• Do all potential traders have access to same
  trading information (bid and ask prices publicly
  displayed.
• Importance of financial services providers
• Dow Jones, Bloomberg, Reuters

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Characteristics of a Well Functioning (Efficient)
Financial Market

• Regulation
• Need to have regulation which ensures level
  playing field and appropriate behavior.
• Discourage insider trading, price manipulations.
• Securities and Exchange Act of 1934 makes it
  unlawful for any person "to use or employ, in
  connection with the purchase or sale of any
  security any manipulative or deceptive device
• SEC 2002 Regulation Fair Disclosure (Reg FD) A
  company releasing market-moving information to
  anyone has to disclose it publicly.

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Characteristics of a Well Functioning (Efficient)
Financial Market

• Competition
• Markets need to be structured and regulated so as
  to offer easy access and exit.
• Not segmenting financial service providers.
• Not overly protecting poorly run firms.
• Will ensure best prices and services for end
  users.
• Market Structure which Allows for Innovation
• To provide needed new services.
• New product development.
• Allow financial service providers to respond to
  needs of end users.
• Development of derivative products in the 1970s
  on.

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Importance of Transparency

• SEC Chairman Arthur Levitt (1998)
• U.S. financial markets are a success precisely
  because they enjoy the world's highest level of
  confidence. Investors put their capital to work
  and put their fortunes at risk because they
  trust that the marketplace is honest. They know
  that our securities laws require free, fair, and
  open transactions.

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Classifications of Financial Markets

• Debt Markets
• Short-Term (maturity lt 1 year) Money Market
• Treasury bills, commercial paper, CDs
• Long-Term (maturity gt 1 year) Capital Market
• Treasury and corporate bonds, mortgages
• Equity Markets
• Ownership claims
• Common stock

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Classifications of Financial Markets

• Primary Market
• New security issues sold to initial buyers (e.g.,
  IPOs)
• Important for raising capital.
• Secondary Market
• Where securities previously issued (in primary
  markets) are bought and sold.
• Through organized exchanges (central locations
  e.g., NYSE, LSE) or over-the-counter arrangements
  (dealers in different locations e.g., NASDAQ,
  and U.S. Government bond market)
• Markets provide liquidity for previously issued
  securities!
• Conversion of financial assets into cash.

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Definition of Financial Instruments

• Financial Instrument
• A claim on an issuers (borrowers) future income
  and/or assets
• Bond Debt instrument with a contractual
  agreement (indenture specifies interest payment,
  maturity date, etc.).
• Stock or equity Ownership position in a
  corporation
• Both bonds and stocks are financial instruments
  and thus part of the financial system
• i.e., they are offered in and trade in financial
  markets.
• Used by issuers to raise capital.
• Businesses, individuals, and governments.
• Both domestic and foreign.

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Financial Instrument Prices

• Debt Instruments (e.g., bonds)
• Look at interest rates
• Market prices move inversely to interest rates.
• Equity Instruments (e.g., common stock)
• Look at market prices.
• Perhaps dividend yields.
• Foreign Exchange
• Look at market prices.

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Observations about Financial Instrument Prices

• Prices potentially not very stable
• Subject to substantial longer term trend changes
• Subject to large short term moves.
• This is what causes problems for participants in
  financial markets!

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Short term interest rates 1970-
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Long term interest rates 1970 -
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NASDAQ Composite 1986 - Present
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Observations about Financial Instrument Prices
Debt and Stock

• Changes in interest rates
• Affect the cost of borrowing and investment
  decisions.
• Influence the returns to interest sensitive
  financial institutions.
• Changes in stock prices
• Affect the economys perception of wealth
• Influence spending decisions (wealth effect).
• Affect the IPO market
• Changes in interest rates and changes in stock
  prices both have an impact on
• Companys cost of capital

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Foreign Exchange Market Yen 1993-
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Observations about Financial Instrument Prices
Foreign Exchange

• Changes in exchange rates
• Affect the returns to global business firms.
• Both non-financial and financial firms.
• Determines the home currency equivalent profits.
• Strong overseas currencies adds to consolidated
  profits.
• Weak overseas currencies lowers consolidated
  profits.
• Affect the competitive position of global firms
• Export and import firms.

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Flow of Funds Through an Economy
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Direct Financial Flows

• Borrowers borrowing directly from lenders by
  selling them securities
• Issuing bonds
• Issuing stocks
• Financial institutions do play a role in this
  process
• Investment bankers underwriting new stock issues.
• However, these financial institutions do not
  manage the funds of lenders, they simply carry
  out transactions!

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Indirect Financial Flows

• Lenders placing funds with financial institutions
  (financial intermediaries) who in turn make
  decisions about lending those funds
• Commercial banks, saving associations, credit
  unions
• Accepting deposits and making loans.
• Insurance companies
• Accepting policy receipts and making investments.
• Mutual funds
• Selling shares and making investments.
• Thus financial institutions stand between lenders
  and borrowers and help transfer funds from one to
  the other.
• This process is called financial intermediation!

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Reasons for Financial Intermediation

• Transactions Costs The time and money spent in
  carrying out financial transactions.
• Search costs and monitoring costs
• Financial intermediaries can reduce transactions
  costs by developing needed expertise and taking
  advantage of economies of scale
• This encourages savers to place funds in these
  financial intermediaries!

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Adverse Selection and Moral Hazard

• Adverse Selection
• Occurs when potential borrowers who are most
  likely to produce an undesirable outcome are the
  ones who are most actively seeking loans.
• Occurs before transaction (loan) takes place.
• Moral Hazard
• The risk that the borrower might engage in
  activities that are undesirable from the lenders
  point of view and result in reducing the
  likelihood of loan repayment.
• Occurs after transaction (loan) takes place.

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Financial Intermediation Adverse Selection and
Moral Hazard

• Adverse selection and moral hazard can occur
  because of asymmetric information
• Inequality or lack of important information.
• Assumption Financial intermediaries are better
  able to deal with adverse selection and moral
  hazard.
• Why They have the expertise to do so.
• Thus, the possibility of encountering adverse
  selection and moral hazard encourages savers to
  place funds in financial intermediaries.

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Observations on Financial Flows

• Majority of funds raised by corporations is
  through financial intermediaries (i.e., indirect
  financing)
• This is true throughout industrial world
• U.S. , U.K., Canada, Germany, France, Japan
• With regard to the direct markets, the picture is
  mixed in the industrial world
• U.S. and Japan bond market is larger than stock
  market.
• France and Italy bond and stock markets about
  equal in size.

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Internationalization (Globalization) of Financial
Markets

• Observations
• Before the mid 1980s, most financial markets were
  segmented (closed) to the rest of the world.
• Exception the U.S. financial markets.
• These markets were also relative small by U.S.
  standards.
• Over the last two decades, financial markets
  around the world have been deregulated to allow
  more free cross border capital flows.
• Growth in savings in foreign markets has
  contributed to the growth in non-U.S. financial
  markets.
• Japan and Western Europe.
• Thus financial markets around the world are
  increasing in importance as sources of funds and
  potential investment.

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Implications of Financial Market Globalization

• Foreign markets are now potentially attractive as
  sources of funds and opportunities for
  investment.
• Major corporations are no longer confined to
  their domestic financial markets for sources of
  funds.
• True for U.S. companies as well.
• Financial institutions are no longer confined to
  their domestic financial markets for investment
  activities.
• Growth of international mutual funds.
• Pension funds investing cross border.
• Banks lending cross border.

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International Financial Markets

• International Bond Market consist of
• Foreign bonds
• Issued by non-residents in the local currency of
  the overseas financial market.
• For Example American corporation issuing a bond
  in Japan denominated in Japanese yen.
• Japanese market has been the preferred
  international bond market lately.
• Eurobonds
• issued by non-residents in other than the local
  currency of the overseas financial market.
• For example American corporation issuing a bond
  in Europe denominated in U.S. dollars.
• Eurodollar denominated bonds the preferred
  choice.
• This market is now larger than U.S. corporate
  bond market.
• Eurobond market is larger than the Foreign Bond
  market.

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Foreign Bond and Euro Bond Markets

• Why are firms attracted to foreign bond market?
• Lower interest rates than at home.
• Situation in Japan today for long term bond
  rates.
• Problem corporates face when issuing a foreign
  bond.
• Need to pay back bond in some foreign currency
• Why are firms attracted to euro bond market?
• Slightly lower interest rates than at home
• No foreign currency exposure if denominated in
  home currency.

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International Financial Markets

• International Money Market
• Eurocurrency loan market Short term loans made
  by major commercial banks to corporates.
• Unsecured loans at floating interest rates.
• Loan rates are usually adjusted every 6 months in
  relation to a benchmark rate.

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International Financial Markets

• World Stock Markets
• U.S. stock market is the largest however,
• Important markets in London, Europe, and Asia!
• Also appearing in emerging markets (e.g., China,
  India).
• Cross listing of stock allows companies to raise
  money globally or in other than their domestic
  market.
• Foreign companies through IPOs in the U.S.
  markets.
• Foreign Exchange Market
• Allows for currency conversions and thus is
  instrumental for moving funds cross-border.
• Dominated by U.S. dollar transactions.
• Largest market in London.

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International Comparisons August 17, 2005

• Country Corporate Spread from
• Bond Rate U.S. rate (basis
  points)
• U.S. 5.13 -----
• Australia 6.19 106
• Canada 5.33 20
• U.K. 5.19 6
• Germany 3.44 - 169
• Japan 1.55 - 358
• Source The Economist.com

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Concluding Statement

• Uncertainty is the central problem confronting
  financial markets.
• Mr. Jacob Frenkl
• Chairman, Merrill Lynch International
• September 2002
• We will develop this theme and issues surrounding
  this throughout this course!
• Financial markets DO NOT like uncertainty!