EWMBA 232 Money Markets and Financial Institutions

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EWMBA 232Money Markets and Financial Institutions

• Prof. Greg Duffee
• Haas School of Business
• Fall 2004

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Institutions and Markets

• Commercial banks
• Investment banks
• Finance companies
• Insurance companies
• Pension funds
• Brokers
• Securities exchanges

• Bonds (Treasury and corporate)
• Stocks
• Money markets
• Mortgages
• Derivatives

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Subject 1 Interest rates
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Subject 2 How are suppliers and demanders of
capital linked?
Financial markets (stocks, bonds)
People with money to invest
Businesses, government
Financial intermediaries
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How are they linked?

• Directly
• Debt markets
• Short and long term borrowing
• Stock markets
• Indirectly, through financial intermediaries
• Key concept asymmetric information
• How good is the investment opportunity?

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An example of asymmetric information

• Duffee has an idea with PV V
• If a firm with deep pockets acquires the idea,
  their marketing power produces PV 1.5V
• Duffee knows V potential purchasers only know
  that V is between 0 and 10MM (each point equally
  likely)
• What should potential purchasers bid for Duffees
  idea?
• This is an adverse selection problem

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Another example

• Duffee has an idea for a project
• Startup cost 100
• Payoff next year depends on effort
• Duffee works hard, liquidating payoff 120
• Otherwise 105
• Duffees happiness Duffees revenue minus sweat
  cost of working
• Working hard costs 10 working less hard costs
  3.125
• Duffee has no money. How does he finance the
  firm?

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• What if Duffee issues equity?
• Sells off a fraction f of the firm for 100.
• Outside investors get f x liquidating payoff,
  Duffee gets residual
• Assume outside investors require a 5 return on
  their investments
• What fraction f do outside investors require?
• If they believe Duffee will work hard
• If they believe Duffee will not work hard
• Duffee is unwilling to sell equity at a price
  outside investors will pay
• This is a moral hazard problem

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Responses to asymmetric information

• Financial intermediaries
• Investment banks, rating agencies use reputation
  effects
• Banks, finance companies work to reduce asymmetry
• Financial instruments
• Certain securities create fewer problems than do
  others (e.g., stocks versus bonds)

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Subject 3 How are primary and secondary markets
structured?

• Demanders of capital want to raise it cheaply and
  prefer long-term commitments
• Suppliers want liquidity
• How do the desires of market participants
  determine the varying structures of primary
  markets (e.g., IPOs, Treasury auctions) and
  secondary markets (e.g., stock exchanges)?
• Can these structures be improved?

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An example of secondary market trading

• Two mutual funds want to buy 3Com stock
• Fund A wants to rebalance
• Fund Bs researchers think 3Com is undervalued
• Trading mechanisms
• Method 1 Trades are given to brokers who display
  them anonymously to professional traders
• Method 2 Trades are negotiated bilaterally and
  sequentially with professional traders
• What trading method do the funds prefer?
• Signaling

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Subject 4 Risks and regulation of financial
intermediaries

• What risks do commercial banks/insurance
  companies/pension funds face?
• How do they manage those risks?
• Why and how are they regulated?

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Subject 5 How are financial market risks
measured, managed, and traded?

• Tools for measuring risk (e.g,, duration)
• Tools for managing risk (e.g., futures and
  forward contracts)
• Tools for trading risks (e.g., synthetic
  collateralized loan obligations)

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Course structure

• Mostly lectures (4 cases)
• Grading
• Midterm 45
• Final 50
• Class participation 5
• Know the cases
• Know old material
• Text is Mishkin and Eakins
• If it is in the book, and I do not talk about it,
  it will not be on a test