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1
Chapter 2: The Financial System
Copyright © Prentice Hall Inc. 1999. Author: Nick Bagley
ObjectiveUnderstanding the workings of
the financial systemDetermining rates
of return
2
Chapter 2 ContentsChapter 2 Contents
• 1 What is a Financial 1 What is a Financial SystemSystem
• 2 The Flow of Funds2 The Flow of Funds
• 3 The Functional 3 The Functional PerspectivePerspective
• 4 Financial Innovation & 4 Financial Innovation & the “Invisible Hand”the “Invisible Hand”
• 5 Financial Markets5 Financial Markets
• 6 Financial Market Rates6 Financial Market Rates
• 7 Financial 7 Financial IntermediariesIntermediaries
• 8 Financial Infrastructure 8 Financial Infrastructure and Regulationand Regulation
• 9 Governmental & Quasi-9 Governmental & Quasi-Governmental Governmental OrganizationsOrganizations
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
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
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
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
2.2 The Flow of Funds2.2 The Flow of Funds
– Funds may flow from the surplus unit Funds may flow from the surplus unit to the deficit unit to the deficit unit • DirectlyDirectly
• Through marketsThrough markets
• Through intermediariesThrough intermediaries
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
The Flow of Funds The Flow of Funds DiagramDiagram
Markets
Intermediaries
Surplus Units Deficit Units
10
The Flow of Funds Diagram
• We shall examine various pathways from the surplus unit to the deficit unit
11
Fund Flows via Market
• A household with surplus funds invests them in government bonds
12
Fund Flows via Market
Markets
Intermediaries
Surplus Units Deficit Units
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
Fund Flows via Intermediary
Markets
Intermediaries
Surplus Units Deficit Units
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
Fund Flows via Intermediary and Market
Markets
Intermediaries
Surplus Units Deficit Units
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
Funds Flow via Markets and Intermediaries
Markets
Intermediaries
Surplus Units Deficit Units
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
Funds Flow: Disintermediation
Markets
Intermediaries
Surplus Units Deficit Units
Markets
Intermediaries
Surplus Units Deficit Units
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
Funds Flow: Secured Credit
Markets
Intermediaries
Surplus Units Deficit Units
Poor Credit Risk
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
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
Transferring Resources Across Time and Space
• A financial system provides ways to transfer economic resources through time, across geographic regions, and amongst industries
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
Managing Risk
• A financial system provides ways to manage Risk
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
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
Clearing and Settling Payments
• A financial system provides ways of clearing and settling payments to facilitate the exchange of goods, services, and assets
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
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
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
Providing Information
• A financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy
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
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
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
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
•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
•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
•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
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
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
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
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
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
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
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
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
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
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
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
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
2.6 Financial Market Rates
• Interest rates
• Exchange rates
• Stock-market indicators
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
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
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
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
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
Exchange Rate Example
15000 ¥
15260 ¥ 15450 ¥
£100
£109
Time
3% ¥/¥ (direct)
1.73% ¥/£/£/¥
•150 ¥/£
9%£/£
140 ¥/£
Japan U.K.
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
Exchange Rate ExampleExchange Rate Example
15000 ¥
16241 ¥ 15450 ¥
£100
£109
Time
3% ¥/¥ (direct)
8.27% ¥/£/£/¥
150 ¥/£
9%£/£
149 ¥/£
Japan U.K.
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
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
Exchange Rate Example
15000 ¥(borrowed)
15450 ¥ 15450 ¥Repaid
£100Invested
£109Matures
Time
3% ¥/¥ (direct)
3% ¥/£/£/¥
150 ¥/£
9%£/£
Forward ¥/£
Japan U.K.
66
Exchange Rate Example
74.141501*09.01
03.01Rate Forward
RateSpot *1
1Rate Forward
1*1Rate Forward*1*RateSpot
1*Yen1
UK
Japan
JapanUK
r
r
Yenrr
•Note: This is for 1 year, but the analysis is easy to generalize
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
US Treasury Yiled Curve, Jan 97
4.50
5.00
5.50
6.00
6.50
7.00
7.50
0 5 10 15 20 25 30
Years to Maturity
An
nu
aliz
ed Y
ield
(%
)
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
Yield Comparisons
April '95 US Corporate CorporateTreasury High Quality Med Quality
1 - 10 Years 6.92% 7.57% 7.86%10 ++ Years 7.65% 8.15% 8.55%
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
Holding Period Return
• Assume:– Purchase price of Share was $100
– Selling price 1-year later was $105
– Cash dividends paid in year were $5
73
Computation of Return
%1010.0100$
5$)100$105($
)(
Return
StartPrice
ndCashDivideStartPriceEndPriceReturn
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
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
Security Returns
-60.00
-40.00
-20.00
0.00
20.00
40.00
60.00
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Year
% R
etu
rn
BillsBonds
StocksInflation
77
Consolidated Indicies
1.0000
10.0000
100.0000
1000.0000
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Year
Ind
ex (
Lo
g S
cale
)
Bills_IndexBonds_Index
Stocks_IndexInflation_Index
78
Frequency of Returns
0
10
20
30
40
50
60
70
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percent
Pro
bab
ilit
y
Freq_BillsFreq_BondsFreq_StockFreq_Inflation
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
Nominal to Real
ateInflationRateInflationReNominalRat
RealRate
ateInflationRRealRateeNominalRat
1
)1(*)1()1(
81
Financial Market Rates
• Interest Rate Equalization– Interest Rate Arbitrage
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
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
Other Depository Savings Institutions
• Depository savings institutions, thrift institutions:– Savings Banks
– Savings and Loans Associations
– Credit Unions
• Compete with Commercial Banks
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
Pension and Retirement Funds
• Defined-Contribution Pension Plan
• Defined-Benefit Pension Plan
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
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
Venture Capital Firms
• Similar to investment banks, but corporate clientele are usually start-up companies
• Help manage company until ready to go public
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
Information Services
• Firms that specialize in providing financial information– Standard and Poor’s; Moody’s
– Best (Insurance)
– Bloomberg; Reuters
– Lipper, Morningstar, SEI
92
2.8 Financial Infrastructure and Regulation
• Rules for Trading
• Accounting Systems
93
2.9 Government and Quasi-Government Organizations
• Central Banks
• Special Purpose Intermediaries
• Regional and World Organizations