Topic 1A An Introduction to Financial Markets

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Topic 1-AAn Introduction to Financial Markets

• Warning
• These lecture slides are provided for the
  exclusive use of students currently enrolled in
  Econ/Fin 6460. Any further distribution of these
  slides is strictly prohibited.

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Saving

• Gross Private
• Personal Forgone expenditures out of current
  income
• Gross Business Saving
• Undistributed corporate profits
• Corporate and noncorporate depreciation
• Gross Government Saving
• Budget surplus (deficit)
• Depreciation
• Net foreign capital inflow

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Gross Investment

• Private
• Government

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Saving-Investment IdentityMacroeconomic
Equilibrium

• Closed Economy No International Trade
• Gross Private Saving Govt Surplus Gross
  Investment
• Open Economy International Trade
• Gross private saving Govt Surplus (Deficit)
  Net Capital Inflow
• Gross investment

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Macro Saving-Investment IdentityNational Income
Accounts 2001-2006Billions of Dollars
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Macro Saving-Investment IdentityNational Income
Accounts 2001 2006Billions of Dollars
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Saving-InvestmentSeparate Economic Agents

• No financial instruments (No borrowing or
  lending)
• Saving Investment
• With borrowing and lending
• gross saving net accumulation of (change in)
  liabilities
• gross investment net accumulation of (change
  in) financial assets

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Flow of Funds

• Equilibrium Identity
• Source of Funds Use of Funds
• This must hold for each sector
• Gross Saving Net Change (Flow) in Financial
  Liabilities
• Gross Investment Net Change in Financial Asset

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Borrowing and Lending

• Borrowing and lending allows separate economic
  agents to invest in excess of their available
  pool of saving
• This ability improves economic efficiency .
• This means a higher level of aggregate economic
  activity and saving and investment than would
  otherwise be possible
• Borrowing and lending
• Requires financial instruments
• Efficiency depends upon the transaction and
  information costs of borrowing and lending

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Financial Versus Real Assets

• Difference is based upon the source of the
  benefit to the asset's holder
• Real asset
• Benefit is provided by the performance of the
  asset
• House Factory
• Computer Airline
• Financial Asset
• Benefit is based on another partys performance
• Bond Saving Account
• Stock Annuity

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Equilibrium Conditions for Macro-Economy and
Separate Economic Agents

• For each economic agent, sector, and the economy
  as a whole
• Sources of funds must equal the uses of funds
• If this condition is met, in the overall or macro
  economy
• Gross private saving Govt surplus (deficit)
  Net foreign capital inflows Gross private
  investment
• and
• Net new financial assets net new liabilities

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Equilibrium Conditions for Macro-Economy

• When saving investment is satisfied,
• Net change in financial assets
• will equal
• Net change in financial liabilities
• Interest rates will adjust to bring about these
  equalities.
• Focus in this course will be on the latter
  identity since that identity reflects financial
  assets, liabilities (financial instruments) and
  financial markets.

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Flow of Funds

• The flows represent changes in the balance sheet
• Since the sources and uses must equal, each
  economic agents balance sheet remains in balance
• Balance Sheet
• Financial asset Financial Liabilities
• Tangible Assets Net Worth
• Total assets Total Liabilities net worth

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Flow of FundsMajor Sectors

• All sectors credit market instruments, excluding
  corporate equities liability
• Domestic nonfinancial sectors credit market
  instruments, excluding corporate equities
  liability
• Federal government credit market instruments
  liability
• Domestic nonfin nonfederal sectors credit market
  instruments, excluding corp equities liability
• Households and nonprofit organizations credit and
  equity market instruments liability
• Nonfarm nonfinancial corporate business credit
  market instruments liability
• Nonfarm noncorporate business credit and equity
  market instruments liability
• Farm business credit and equity market
  instruments liability
• State and local govt, excluding employee
  retirement funds credit market instruments
  liability
• Rest of the world credit market instruments,
  excluding corporate equities liability
• Total finance credit market instruments,
  excluding corporate equities liability

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Overall Borrowing and Lending EquilibriumFlow of
Funds BasisMillions of Dollars 2007Q1
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Flow of FundsFinancial Sector
Monetary authority credit market instruments
asset Commercial banking credit market
instruments Savings institutions credit market
instruments asset Credit unions credit market
instruments Bank personal trusts and estates
credit market instruments Life insurance
companies credit market instruments Other (that
is, property-casualty) insurance companies credit
market instruments Private pension funds credit
market instruments State and local government
employee retirement funds credit market
instruments Federal government retirement funds
credit market instruments Money market mutual
funds credit market instruments asset Mutual
funds credit market instruments asset Closed-end
funds credit market instruments
asset Exchange-traded funds credit market
instruments asset Government-sponsored
enterprises credit and equity market instruments
asset Agency-and GSE-backed mortgage pools total
mortgages Issuers of asset-backed securities
credit and equity market instruments
asset Finance companies credit and equity market
instruments asset Mortgage companies total
mortgages (total financial assets) asset Real
estate investment trusts credit market
instruments asset Security brokers and dealers
credit market instruments, excluding corporate
equities asset Funding corporations credit market
instruments, excluding corporate equities asset
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Determination of the Real Risk-Free Rate

• For each economic agent, sector and the economy
  as a whole
• Sources of funds must equal the uses of funds
• If this is done, the following will be satisfied
  in the aggregate
• Gross private saving govt surplus (deficit)
  net foreign capital inflows
• will equal
• Gross investment

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Determination of the Real Risk-Free Rate

• When saving investment is satisfied,
• Net change in financial assets
• will equal
• Net change in financial liabilities
• Interest rates will adjust to bring about these
  equalities.
• Focus is now on the last equilibrium relationship
  since this reflect financial assets and
  liabilities (financial instruments) and markets

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Determination of the Real Risk-Free Rate

• If a source or use shifts for any agent or
  sector, it will have a feed-through effect on the
  entire economy
• This leads to the loanable funds model of the
  determination of the general level of interest
  rates.
• In equilibrium,
• Supply of funds demand for funds
• This is same as
• Net change in financial assets net change in
  liabilities

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Determination of the Real Risk-Free Rate

• Point at which the demand for funds equals the
  supply of funds
• This is the real risk free rate discussed in
  finance corporate finance courses
• If demand for funds increases, the real risk-free
  rate rises
• If the supply of funds increases, the real
  risk-free rate declines
• The nominal level of interest rates
• the real rate plus the inflation premium

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The Equilibrium Real Risk-Free Rate
Real Rate
Supply of funds or Demand for Financial Assets
Demand for funds or Supply of Liabilities
Quantity of Funds
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The Risk-Free Rate

• Nominal
• Rate

Inflationary Expectation
Quantity of Funds
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Financial versus Nonfinancial Firm

• Both acquire assets with intention that the value
  of the benefits provided by the assets their
  costs
• Difference depends on the firms dominant asset
• Nonfinancial firm Mostly real assets
• Financial firm Mostly financial assets
• Until 1980s, the difference was dramatic. Now,
  distinction is blurring
• Many nonfinancial firms own sizable financial
  firms.

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The Role of Financial Firms

• One broad function
• Bring together those in need of funds with those
  that have excess funds
• This is done through two broad routes
• Some institutions borrow from savers and re-lend
  to borrowers (intermediaries)
• Some institutions facilitate the direct relation
  between savers and borrower

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Why Do Financial Firms Exist?

• These firms improve the efficiency of financial
  transactions
• Improved efficiency means that the costs of funds
  to the borrowers are reduced
• Broadly speaking, these firms lower information
  costs and transactions cots
• More specifically, financial firms lower the
  following costs
• Search costs Risk management costs
• Portfolio selection costs Liquidity costs
• Monitoring costs

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Types of Financial Institutions

• Depository Institutions
• Commercial banks
• Thrifts institutions
• Saving and loan institutions
• Saving banks
• Credit Unions
• Contractual Intermediaries
• Insurance companies
• Life insurance
• Property and casualty
• insurance
• Pension funds

• Finance Companies
• Securities Firms
• Investment bankers
• Brokers
• Dealers
• Investment Companies
• Money market mutual funds
• Bond mutual funds
• Equity Mutual funds
• Government institutions
• Government sponsored institutions

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Financial Institutions and Types of Finance and
Securities

• Broad Types of Finance
• Direct finance Investors hold the obligation of
  the final borrower
• Indirect finance An intermediary holds the
  obligations of the ultimate borrowers the
  intermediary borrows the funds from investors to
  re-lend to the ultimate borrower
• Classes of Securities
• Primary securities direct obligations of the
  ultimate borrowers
• Secondary securities obligations of the
  intermediary issued to acquire funds with which
  to acquire the primary security

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Objective of Financial Institutions

• Single objective the maximization of shareholder
  value
• This is a normative objective, i.e., it is the
  way managers should behave
• But, this is not always the way that they do
  behave
• Principal-Agency problem an explanation of how
  managers may actually behave
• Agents the managers
• Principal the owners
• Many times, the agents behave in a way that
  maximizes their well-being to the detriment of
  the principals well-being

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Factors Affecting Corporate Objectives

• Customer needs
• Demand for liquidity of the secondary securities
  issued by the financial institution. The need to
  provide this liquidity constrains the firms
  behavior
• Ownership structure
• Stock owner versus mutually owned. Mutual owners
  are not entitled to personal claim on residual
  profits.
• Evidence on behavior
• There is a problem but there are limits
• Monitoring actions by owners
• Contracts
• Market for corporate control

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Markets

• Primary market market where securities are
  traded for the first time, i.e., the market were
  newly issued securities are traded
• Secondary market market where previously issued
  securities are traded

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Secondary Markets

• The Roles
• Provides liquidity to securities
• Provides guidance to primary market on
  appropriate price of a new issue
• Provides information on the value of securities
• Disseminates information
• Provides ability to reverse decisions
• Provides ability to acquire a diversified
  portfolio

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Secondary Markets

• Organization
• Organized exchanges
• OTC
• Participants
• Brokers
• Dealers
• Structure
• Continuous (exchanges and otc)
• Call (exchanges)
• An auction type market
• Trades clear at set point(s) in day at single
  price

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Efficiency and Secondary Markets

• Operational Efficiency
• Investors can obtain securities as cheaply as
  possible
• Transaction costs
• commissions, fees, execution costs, and
  opportunity costs)
• Bid-ask spreads
• Information (Pricing)
• Price reflects all available information relevant
  to the valuation of the security

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Secondary MarketsInformation (Price) Efficiency

• Weak efficiency
• Price fully reflects past price and treading
  history
• Semi-strong efficiency
• Price fully reflects all public information
• Strong efficiency
• Price fully reflects all information, private or
  otherwise
• Implication
• Activists (trading) strategy will not
  consistently generate return higher than buy and
  hold

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Secondary marketsOperational Efficiency

• Transaction costs
• Commission, fees, execution costs, and
  opportunity costs
• Fees
• Custodial
• Transfer
• Execution costs
• Market (price) impact
• Market timing costs
• Opportunity costs
• Consequences of failing to execute all desired
  trades

• Bid-ask spread
• Depends upon liquidity of the market
• Factors determining liquidity
• Depth
• Orders exits above and below current trading
  price
• Breath
• If orders that give market its depth are in large
  volume
• Resiliency
• New orders flow in quickly in response to prices
  changes

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Secondary marketsOperational Efficiency

• The type of secondary market influences liquidity
• Direct search
• Least liquid buyers and sellers must find each
  other
• Brokered
• Brokers offer to find counterparty for a fee
• Could be execution delays since broker must still
  find counterparty
• Uncertainty over speed of execution leas to
  heightened price risk

• Dealer
• Buy and sell for their own account at the market
  (quoted) price
• These are market makers
• Compensation
• Bid-ask spread
• Trading profit from price changes
• Carry on inventory
• Auction
• Centralized process to expose all participants to
  purchase and sale orders immediately