Institutions and Markets

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Institutions and Markets

• Economics 71a
• Spring 2005
• Gitman/Joehnk Chapter 2
• Lecture notes 3

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Goals

• Financial institutions
• Financial markets
• Financial transactions

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Institutions (the players)

1. Commercial banks
2. Mutual funds
3. Pension funds
4. Securities firms
5. Insurance companies
6. Others

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1. Commercial Banks

• Consumers
• Deposits/savings
• Lending/transactions
• Consumer loans
• Home mortgages
• Checking accounts
• Credit cards
• Debit cards
• Foreign exchange
• Brokerage (recent)

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1. Commercial Banks

• Firms
• Cash management
• Lines of credit
• Loan of varying magnitude
• Similar to credit card
• Bank loans (term loans)

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1. Commercial Banks

• Intermediary roles
• Between lenders and borrowers
• Repackaging financial products
• Regulatory environment
• Key aspect of monetary policy
• Federal Deposit Insurance Corporation (FDIC)
• Federal Reserve System

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2. Mutual Funds

• Function
• Consumer investments -gt Firms
• Types
• Stock (invest in stock market portfolios)
• Money market (short term lending to firms)
• Bond
• Real Estate

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2. Mutual Funds

• Allow consumers to better diversify
• Gather and process investment information
• Major industry in Boston

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3. Pension Funds

• Manage/invest employee savings/pension plans
• Similar in spirit to mutual funds
• Hired by employer

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4. Securities Firms

• Investment banks/brokerage firms
• Issue stock and bonds
• (IPO Initial public offering)
• Facilitate trades in securities
• Banks versus Investment Banks
• The repeal of Glass-Steagall (1999)

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5. Insurance Companies

• Insure individual and corporate risks
• Receive payments (insurance premia)
• Payout for losses
• New issues
• Trading insurance policies
• Derivatives
• High tech risk management

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6. Other Institutions

• Savings and loans
• Savings -gt home mortgages
• Credit unions
• Information and software services
• Bloomberg
• Quicken
• Microsoft

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Goals

• Financial institutions
• Financial markets
• Financial transactions

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Markets

• Primary markets
• New issues (IPOs, corporate and public debt)
• Secondary markets
• Trading old stuff
• In many cases most activity in secondary

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Money and Capital Markets

• Money markets
• Short term securities (1 year or less)
• Capital markets
• Longer term

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Money Market Securities

• Treasury bills
• U.S. government debt
• Short term (less than 1 year)
• Commercial paper
• Short term corporate borrowing
• Discount pricing
• Buy for 10, get paid 11 in future
• No interest payments

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Capital Market Securities

• Bonds (longer term borrowing)
• U.S. Treasury
• Municipal (tax free)
• Corporate
• More later

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Capital Market Securities

• Stocks
• Common stock
• Preferred stock
• International
• More later

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Primary Market

• Initial public offering (IPO)
• Initial sale of stock or bond
• Late 1990s boom

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IPO Timing

• Private firm
• Negotiations between shareholders and other
  initial investors (Venture Capital)
• Find investment bank to handle IPO
• Prospectus filed with Securities and Exchange
  Commission
• Red Herring Version of prospectus for initial
  investors
• Quiet period filing to 1 month after IPO
• Restrictions on public information releases

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Investment Banks

• Originating investment bank
• Underwriting syndicate
• Insures shares will be purchased
• Selling group
• How do people get paid?
• Underwriters pay IPO firm (15/share)
• Sell to selling group (16/share)
• Sell to investors (17/share)
• Scandals and IPO prices

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Trading and Secondary Markets

• Stock markets
• Bond markets
• Derivatives
• Foreign Exchange

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U.S. Stock Markets

• New York Stock Exchange (NYSE)
• National Association of Securities Dealers
  Automated Quotation (Nasdaq)
• American Stock Exchange (AMEX)

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Continuous Trading

• Market types
• Specialist
• Electronic dealer
• Open outcry
• Over the counter
• NASDAQ
• Upstairs (negotiated)
• ECN (electronic crossing network)

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ECNs Electronic Crossing Networks

• Internet based trade networks
• Customers can meet directly (no broker)
• Used mostly by professional money managers
• Advantage fewer intermediaries
• Disadvantage less liquidity
• (Fewer people to trade with)
• Fastest growing markets

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Other Markets

• Futures/Options
• Foreign Exchange
• Spot versus forward
• Bond

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International Markets

• Many major international stock markets
• London
• Tokyo
• China
• many more
• US accounts for only 36 of the companies listed
  on stock markets around the world

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Why Should U.S Investors Care?

• Diversification
• Performance
• Industries

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How Can U.S. Investors Invest Globally?

• Multinational firms
• Microsoft
• Ford
• Mutual funds
• Direct purchases
• US securities/foreign firms (Yankee Bonds)
• American deposit receipts (ADRs)
• WEBS (World Equity Benchmarks)

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International Risks

• Macroeconomic risks
• Political risks
• Exchange rate risks

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Trading Hours

• Most U.S. stock markets
• 930-400
• Extended hours on electronic trading networks
• After hours trading
• International markets (local times)
• Foreign exchange markets (24 hours)
• Hours increasing toward a 24 hour market

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Market Regulation

• Securities laws protect investors
• Federal and state laws
• Securities and exchange commission (SEC)
  established in 1934
• Important laws
• Securities act of 1933 (IPO rules)
• Insider trading and fraud act of 1988
• Sarbanes-Oxley act of 2002
• Tighter controls on accounting information

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Goals

• Financial institutions
• Financial markets
• Financial transactions

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Long Purchase

• Straight purchase of a security
• Speculate that price will increase
• Buy at 100
• Sell at 110
• 10 return

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Margin Purchase

• Buying on margin
• Borrow money to buy stock
• Buy at 75 margin
• 75 of money in investment is yours
• 25 is borrowed from broker or bank
• Purchase 100 of stock at 75 margin
• You put in 75, and you borrow 25

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Basic Margin Formula
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Margins and Magnification

• Example stock Price 100
• Up Price 150
• Down Price 75
• If you purchased with your own money
• 100 total investment
• Up 50
• Down - 25

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Margins and Magnification

• Buy on 50 margin (zero interest charges)
• 100 own, and 100 borrowed (needs to be paid
  back)
• Purchase 200/100 shares 2 shares
• 100 total investment
• Up 2150 - 100 - 100 100 (50)
• Down 275 - 100 - 100 -50 (-25)

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Margin Buying

• Borrowing money to buy stocks
• Magnifies gains and losses
• Can lose more than you put in
• Buy 200 of stock
• 100 your own
• 100 borrowed
• Stock goes to zero
• Lose 100 of own investment, and
• Owe 100 of borrowed money too

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Maintenance Margins

• Margin required for investor to maintain
• If margin falls below this level investors must
  add more of their own money
• Margin call
• Common margin call
• Prices fall
• Margin rises
• Investor needs to come up with more funds

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Margin Requirements

• Common stock 50
• Bonds 50
• Options 20 stock value
• Futures 2-10 of the contract value

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Short Sales

• Holding negative stock
• Sell stock you dont have (borrow)
• Buy it back later
• Pay dividends yourself in between
• Key issue
• Make money on a price fall
• Lose money on a rise
• Betting against a stock

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The Mechanics of a Short

• Tell broker you want to sell 100 shares of IBM
  short (price 50)
• Broker borrows shares of 100 shares of IBM
  owned by another client
• Sells it to someone for 501005000, and pays
  this to you
• You must keep this amount on account with broker
• When dividends are to be paid, you pay broker,
  and broker pays the other client

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The Mechanics of a Short

• IBM goes down to 40 per share
• You buy your 100 shares to take you back to
  zero, pay broker 401004000.
• Broker buys at market, and puts the shares back
  in the other persons account
• You make 5000-4000 1000 (less dividends)
• Make money when price falls
• Lose money when price rises

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The Mechanics of a Short

• IBM goes up to 60 per share
• You buy your 100 shares to take you back to
  zero, pay broker 601006000.
• Broker buys at market, and puts the shares back
  in the other persons account
• You lose 5000-6000 -1000 (less dividends)

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Margins and Shorts

• Broker requires additional funds to cover
  possible losses
• Fraction of additional sale amount
• Example
• Sell 5000 worth of stock at 60 margin
• Need to keep 0.65000 3000 on account with the
  broker
• Maintain fraction of value of the stock in this
  account
• When the price goes up, need to increase this
• Margin call

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Oddities About Shorts

• Can lose unbounded amounts of money
• Normally only lose what you put in
• With short price can go up forever, and your
  losses keep increasing
• Also, broker can get in trouble if you default
• Other customer could lose original shares
• Often insured for this

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Short Interest

• Fraction of shares sold short
• Measure of market pessimism in a stock
• Common market indicator
• Measures market pessimism

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Squeeze Play

• Assume Microsoft has a large number of short
  sellers
• Price starts to rise
• Short sellers losing money
• Get nervous
• Buy stock to close out their short positions
• Prices rise more, more buying .. (etc. etc)

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Goals

• Financial institutions
• Financial markets
• Financial transactions