International Finance

1
International Finance

• By Professor Jermaine Whirl
• For Students of East Georgia College

2
Current Financial Crisis

• As we've been studying macroeconomics this
  semester we take the time to concentrate briefly
  on the financial crisis in America.
• The crisis can really be explained in several
  explanations
• Implicit Options
• Moral Hazard
• Asymmetric Information
• Principal Agent-Problem

3
Financial Options

• Options are financial instruments that convey the
  right, but not the obligation, to engage in a
  future transaction.
• The biggest option that banks write are
  mortgages.
• Mortgages are implicit options. Implicit meaning
  involved in the nature or essence of something
  though not revealed.

• Therefore, when the bank sells an implicit
  option, the mortgage holder has a right, but not
  an obligation to hold his side of the deal.
• If the mortgage holder cannot afford to pay to
  mortgage they "put" the mortgage back to the
  bank.
• This is detrimental to the bank, because they
  just locked in 10,15,20, or 30 year financial
  spreads, and now they just lost that spread by
  having to take back the put.
• These mortgages are known as sub-prime mortgages.

4
Yield Curve
Yield Curve the yield curve is the relation
between the interest rate (or cost of borrowing)
and the time to maturity of the debt for a given
borrower in a given currency.
Banks base their lending on the yield curve. If
the curve begins to flatten then their "interest
spreads" are shorter and therefore they need more
liquidity.
5
Moral Hazard

• Moral hazard is the prospect that a party
  insulated from risk may behave differently from
  the way it would behave if it were fully exposed
  to the risk.

• Moral hazard arises because an individual or
  institution does not bear the full consequences
  of its actions, and therefore has a tendency to
  act less carefully than it otherwise would,
  leaving another party to bear some responsibility
  for the consequences of those actions.

6
Financial Crisis- Moral Hazards

• Not only did the banks have a short put on them
  because of implicit options, but they too had an
  implicit option on the government.
• Firms decided to load up on risk, because they
  felt if things don't work out, they'll just put
  the burden on the government.
• Example AIG, Fannie Mae, Freddy Mac, Lehman
  Brother (not bailed out), Washington Mutual Bank-
  (bought out) by another bank.
• This is risk profiling.

7
Asymmetric Information

• a situation in which one party in a transaction
  has more information than another. The party that
  is insulated from risk generally has more
  information about its actions and intentions than
  the party paying for the negative consequences of
  the risk.

• More broadly, moral hazard occurs when the party
  with more information about its actions or
  intentions has a tendency or incentive to behave
  inappropriately from the perspective of the party
  with less information.

8
Principal Agent Problem

• where one party, called an agent, acts on behalf
  of another party, called the principal. The agent
  usually has more information about his or her
  actions or intentions than the principal does,
  because the principal usually cannot perfectly
  monitor the agent.

• The agent may have an incentive to act
  inappropriately (from the view of the principal)
  if the interests of the agent and the principal
  are not aligned.