FNCE 3020 FINANCIAL MARKETS AND INSTITUTIONS

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FNCE 3020FINANCIAL MARKETS AND INSTITUTIONS

• Professor Michael Palmer
• Professor of Finance
• University of Colorado at Boulder
• Fall Semester 2007
• Lecture 1 Introduction and Basic Concepts

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What is your current understanding of financial
markets?

• Who is the current chairman of the Federal
  Reserve?
• Who was the previous chairman of the Federal
  Reserve?
• What is the Federal Reserve responsible for?
• Define the Federal Funds rate, the Discount Rate,
  the Prime Rate?
• What is the current level of the Federal Funds
  Rate?
• Is the Federal Funds Rate higher or lower than
  one year ago?
• Which country currently has the highest (lowest)
  short term (long term) interest rate?
• United States, United Kingdom, Japan, Germany,
  Australia
• Which is bigger, the worlds stock markets or the
  worlds bond markets?
• Which country has the largest stock market (by
  capitalization)?
• Japan, the United States, the United Kingdom
• Which of the following central banks is the
  newest?
• The Federal Reserve, the Bank of England, the
  Bank of Japan, the European Central Bank.

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Ben Bernanke The 14th Chairman of the Federal
Reserve Board

• Ben Bernanke replaced Alan Greenspan on February
  1, 2006
• Greenspan had served since August 1987.
• Background The Chairman of the Federal Reserve
  Board is named by the President and is confirmed
  by the U.S. Senate. They serve a term of four
  years, and can be reappointed.
• The Federal Reserve is responsible for the
  conduct of monetary policy, which means, setting
  interest rates and promoting money supply growth,
  with the main goal of promoting price stability.
• Columbia Business School's Video parody of Dean
  Glenn Hubbard (Note he is not the real Dean)
  singing about wanting Alan Greenspan's job that
  went instead to Ben Bernanke.
• http//www.youtube.com/watch?v3u2qRXb4xCUeurl

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Federal Funds Rate

• The short term rate in the U.S. interbank market
  for bank reserves.
• One bank lending reserves to another.
• This is a key (benchmark) short interest rate
  in the United States
• It is set (and managed) by the Federal Reserve.
• Changes (or lack thereof) indicate the stance
  (direction and accommodation) of monetary policy.
• Other interest rates follow closely (especially
  short term rates).
• Markets all over the world pay close attention to
  the Fed Funds Rate as well as other major central
  bank equivalent rates.

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U.S. Federal Funds Rate

• Current Level 5.25, Raised from 5 to 5.25 in
  July 2006. (July 2004 1.0 July 1974 13)

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Federal Reserve Discount Rate and Prime Interest
Rate

• Federal Reserve Discount Rate Interest rate the
  Federal Reserve will charge member banks to
  borrow short term reserves.
• Currently 5.75 (changed from 6.25 on August
  17, 2007)
• Prime Rate Interest rate commercial banks will
  charge their best customers on loans to borrow
  short term funds.
• Currently 8.25

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Fed Funds Rate and Prime Rate
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Interest Rates, August 15, 2007

• Source http//www.economist.com/markets/indicator
  s/

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Interest Rates A Year Ago August 17, 2006
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Final Three Questions

• Which is bigger, the worlds stock markets or
  worlds bond markets?
• Stock Markets 37 trillion
• Bond Markets 59 trillion (2005 data)
• Which country has the largest stock market (by
  capitalization)? Japan, the United States, the
  United Kingdom
• Japan 7.3 trillion
• United Kingdom 3.4 trillion
• United States 17 trillion
• Which of the following central banks is the
  newest? The US Federal Reserve, Bank of England,
  Bank of Japan, the European Central Bank.
• US Federal Reserve 1913.
• Bank of England 1694
• Bank of Japan 1882
• European Central Bank 1999

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Financial Markets and Financial Institutions

• How would you define these?
• Perhaps in terms of functions?
• Perhaps in terms of institutions?

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Working Definitions

• Financial Markets
• Markets through which entities with surplus
  (excess) financial funds transfer those surplus
  funds to entities who have a shortage
  (shortfall) of available funds.
• Stock markets, bond markets, mortgage markets,
  money markets
• Financial Institutions
• Entities that facilitate and manage the movement
  of funds from surplus entities to final
  borrowers.
• Commercial banks, investment banks, asset
  managers (pension funds, insurance companies),
  hedge funds, foreign exchange brokers

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Functions of Financial Markets

• Mechanism for raising funds!
• In primary financial markets (e.g., IPOs)
• Mechanism for converting financial assets into
  cash before maturity.
• In secondary financial markets (e.g., NYSE, OTC
  bond markets)
• Provides the means for entities to protect their
  financial/commercial positions.
• In derivatives markets (options, futures,
  forwards)
• Mechanism for generating a return on
• surplus funds.
• Through interest, dividends, capital appreciation

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Functions of Financial Markets

• Allocates financial resources among
• competing users.
• And, we assume, if done so in the most efficient
  manner (i.e., to the most productive users)
• The process will improve economic efficiency and
• Result in highest possible economic growth!
• Provides financial signals to market participants
• Interest rates, stock prices, exchange rates!
• Tells us something about individual entities (for
  example, companies, government borrowers).
• Tells us something about global perceptions of
  countries.

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Characteristics of a Well Functioning (i.e.,
Efficient) Financial Market

• Market Transparency
• All participants need to have access to reliable
  and important information at the same time.
• Importance of trading platforms.
• How quickly is trading information made
  available?
• Do all potential traders have access to same
  trading information (bid and ask prices publicly
  displayed).
• Importance of financial services providers
• Dow Jones, Bloomberg, Reuters.
• Central banks and central bankers play in role in
  this process by pursuing transparency in terms of
  their monetary policy processes.
• Web sites http//www.bis.org/cbanks.htm

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Characteristics of a Well Functioning (i.e.,
Efficient) Financial Market

• Proper Regulation
• Need to have regulation which ensures a level and
  fair playing field and appropriate behavior.
• Discourage insider trading, price manipulations,
  unethical behavior provide appropriate reporting
  of financial information to markets.
• Securities and Exchange Act of 1934 makes it
  unlawful for any person "to use or employ, in
  connection with the purchase or sale of any
  security any manipulative or deceptive device
• SEC 2002 Regulation Fair Disclosure (Reg FD) A
  company releasing market-moving information to
  anyone has to disclose it publicly.
• Issue for regulators A what point does
  regulation become a burden and/or drive financial
  service providers to other markets?
• Issue of hedge funds today and offshore markets
  in the 1960/70s.

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Characteristics of a Well Functioning (i.e.,
Efficient) Financial Market

• Competition
• Markets need to be structured and regulated so as
  to offer easy access and exit.
• Not segmenting financial service providers.
• Not overly protecting poorly run firms.
• Applies to both domestic and foreign entities.
• Will ensure best prices and services for end
  users.
• UK has traditionally been a very open market.
• Market Structure which Allows for Innovation
• To provide needed new services and new product
  development.
• Allow financial service providers to respond to
  needs of end users.
• Development of derivative products in the 1970s
  through today.

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Importance of Transparency to Financial Markets

• (Former) SEC Chairman Arthur Levitt (1998)
• U.S. financial markets are a success precisely
  because they enjoy the world's highest level of
  confidence. Investors put their capital to work
  and put their fortunes at risk because they
  trust that the marketplace is honest. They know
  that our securities laws require free, fair, and
  open transactions.
• However, financial scandals in U.S. resulted in
  the passage of The Sarbanes-Oxley Act (SOX) in
  July 2002
• Question Has SOX put US markets at a
  competitive disadvantage or competitive
  advantage?

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Classifications of Financial Markets

• Debt Markets
• Short-Term (maturity lt 1 year) Money Market
• Treasury bills, commercial paper, CDs
• Long-Term (maturity gt 1 year) Capital Market
• Treasury and corporate bonds, mortgages
• Equity Markets
• Ownership claims
• Common stock
• Derivative Markets
• A security whose value is based upon some
  underlying asset.
• Futures, forwards, options (puts and calls)
• Originated in Chicago in the 1850s (CBOT) for
  commodities (flour, hay, corn), but now involves
  financial assets as well.

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Classifications of Financial Markets

• Primary Financial Market
• New security issues sold to initial buyers
  (e.g., IPOs)
• Important for raising new capital (involves
  public and private placements and investment
  bankers)
• Secondary Financial Market
• Where securities previously issued (in primary
  markets) are bought and sold.
• Secondary markets provide liquidity for
  previously issued securities -- Conversion of
  financial assets into cash before asset matures.
• Done through organized exchanges (central
  locations e.g., NYSE, LSE) or through
• Over-the-counter arrangements (dealers in
  different locations e.g., NASDAQ, and U.S.
  Government bond market)

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Definition of Financial Instruments

• Financial Instrument
• A claim on the issuers future income and/or
  assets
• Bond Debt instrument with a contractual
  agreement (indenture specifies interest payment,
  maturity date, etc.).
• Stock or equity Ownership position in a
  corporation
• Both bonds and stocks are financial instruments
  and thus part of the financial system
• i.e., they are offered in and trade in financial
  markets.
• Used by issuers to raise capital.
• Businesses, individuals, and governments.
• Includes both domestic and foreign entities.

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Observations about Financial Instrument Prices

• Prices potentially not very stable
• Subject to substantial longer term trend changes
• Subject to large short term moves.
• Prices measured in terms of interest rates or
  asset prices themselves.
• This is what causes problems for participants in
  financial markets (both borrowers and lenders)!
• Lets look at a examples of
• interest rates and stock prices

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Short term interest rates 1970-
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Long term interest rates 1970 -
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Stock Prices 1990 -
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Stock Prices 2007

• Go to
• http//moneycentral.msn.com/investor/charts/chartd
  l.aspx?Symbol24INDUCP0PT5

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Impact of Changes in Financial Variables

• Changes in interest rates
• Affect the cost of borrowing and asset prices.
• Influence the returns (and profit margins) to
  interest sensitive financial institutions.
• Impact on the MA market.
• Impact on mortgage markets.
• Changes in stock prices
• Affect the economys perception of wealth
• Influence spending decisions (wealth effect).
• Affect the IPO market and MA market
• Impact on Corporate Investment Decisions changes
  in interest rates and changes in stock prices
  both have an impact on a companys cost of
  capital.

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Volatility in Foreign Exchange Market Yen 1993-
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Impact of Foreign Exchange Rates

• Changes in exchange rates
• Affects the returns to global business firms.
• Both non-financial and financial firms.
• Determines the home currency equivalent profits.
• Strong overseas currencies adds to consolidated
  profits (i.e., home currency equivalent) Yen
  1995
• Weak overseas currencies lowers consolidated
  profits (i.e., home currency equivalent) Yen
  1998
• Affects the competitive position of global firms
• Competitive position of export and import firms.
• Cost structure of multinational firms operating
  in overseas markets.

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Direct Versus Indirect Finance

• A financial system offers two different ways for
  funds to flow from investors (lenders) to
  borrowers 
• (1) direct flows to borrowers through financial
  markets, and
• (2) indirect flows through financial
  intermediaries, such as commercial banks, pension
  funds, and mutual funds.
• Direct Finance involves the transfer of funds
  from the initial investor to the ultimate
  borrower, generally through a third party. 
• Direct securities are usually sold to the public
  through an underwriter, i.e., a financial firm
  that purchases them from the issuer with the
  intention of reselling them at a profit.
• Indirect Finance involves the flow of funds from
  the initial investor to a financial intermediary
  who pools the funds of many investors in order to
  relend at a markup over the cost of the funds. 
• Ultimate borrowers are normally unknown to the
  initial investor. 

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Illustrating the Flow of Funds Through an Economy
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Direct Financial Flows

• Borrowers obtaining funds directly from lenders
  (investors) by selling them financial securities
• Issuing bonds in primary markets
• Issuing stocks in primary markets
• Financial institutions play a role in this
  process
• Investment bankers underwriting new publicly
  offered issues or arranging for private
  placements.
• However, these financial institutions do not
  manage the funds of lenders, they simply carry
  out transactions.
• These financial institutions act as dealers, in
  that the facilitate the transfer of securities
  from original issuers to investors.

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Indirect Financial Flows

• Lenders, depositors, investors placing funds with
  financial institutions who in turn make decisions
  about lending or investing those funds
• Commercial banks, saving associations, credit
  unions
• Accepting deposits and making loans.
• Insurance companies
• Accepting policy receipts and making investments.
• Mutual funds (UK Unit Trusts)
• Selling shares and making investments.
• Hedge funds, private equity, mortgage brokers,
  finance companies
• Raising capital (debt or equity) and making
  investments
• In this capacity, these financial institutions
  act as financial intermediaries.
• This process is called financial intermediation.

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Reasons for Financial Intermediation

• Transactions Costs Refers to the time and money
  spent in carrying out financial transactions.
• This involves search costs and monitoring costs
• Financial intermediaries can reduce transactions
  costs by developing needed expertise and taking
  advantage of economies of scale
• This encourages savers to place funds in these
  financial intermediaries.

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Adverse Selection and Moral Hazard

• Adverse Selection
• The risk that potential borrowers who are most
  likely to produce an undesirable outcome are the
  ones who are most actively seeking loans.
• Occurs before transaction (loan) takes place.
• Moral Hazard
• The risk that the borrower might engage in
  activities that are undesirable from the lenders
  point of view and thus reduce the likelihood of
  loan repayment.
• Occurs after transaction (loan) takes place.
• Moral Hazard and Adverse Selection Issues can
  also be applied to the activities of lenders.

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Financial Intermediation Adverse Selection and
Moral Hazard

• Adverse selection and moral hazard can occur
  because of asymmetric information
• Inequality or lack of important information.
• Assumption Financial intermediaries are better
  able to deal with adverse selection and moral
  hazard.
• Why They have the expertise to do so.
• Thus, the possibility of encountering adverse
  selection and moral hazard encourages savers to
  place funds in financial intermediaries.

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Observations on Financial Flows

• Majority of funds raised by corporations is
  through financial intermediaries (i.e., indirect
  financing)
• This is true throughout industrial world
• U.S. , U.K., Canada, Germany, France, Japan
• With regard to the composition of the direct
  markets, the picture is mixed in the industrial
  world
• U.S. and Japan bond market is larger than stock
  market.
• France and Italy bond and stock markets about
  equal in size.

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Internationalization (Globalization) of Financial
Markets

• Observations
• Before the mid 1980s, most financial markets were
  segmented (closed) to the rest of the world.
• Exception the U.S. financial markets.
• These markets were also relative small by U.S.
  standards.
• Over the last two decades, financial markets
  around the world have been deregulated to allow
  more free cross border capital flows.
• Growth in savings in foreign markets has
  contributed to the growth in non-U.S. financial
  markets.
• Japan and Western Europe.
• Thus financial markets around the world are
  increasing in importance as sources of funds and
  potential investment.

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Implications of Financial Market Globalization

• Foreign markets are now potentially attractive as
  sources of funds and opportunities for
  investment.
• Major corporations are no longer confined to
  their domestic financial markets for sources of
  funds.
• True for U.S. companies as well.
• Financial institutions, and individual investors,
  are no longer confined to their domestic
  financial markets for investment activities.
• Growth of international mutual funds for
  investors
• Pension funds investing cross border.
• Banks lending cross border.
• Growing impact of hedge funds and private equity.

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International Comparison of Household Financial
Asset Allocation
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International Comparisons August 2005 and
August 2006

• Country Corporate Spread from Corporate
  Spread from Bond Rate U.S. rate
  Bond Rate U.S. rate
• (2005) (2005) (2006)
  (2006)
• U.S. 5.13 ----- 5.89
  -----
• Australia 6.19 106 6.98
  109
• Canada 5.33 20 5.51
  - 38
• U.K. 5.19 6 5.74
  - 15
• Germany 3.44 - 169 4.51
  - 138
• Japan 1.55 - 358 2.04
  - 385
• Source The Economist.com

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International Comparisons August 2006 and
August 2007

• Country Corporate Spread from Corporate
  Spread from Bond Rate U.S. rate
  Bond Rate U.S. rate
• (2006) (2006) (2007)
  (2007)
• U.S. 5.89 ----- 6.05
• Australia 6.98 109
  7.73 168
• Canada 5.51 - 38
• U.K. 5.74 - 15 6.48
  43
• Germany 4.51 - 138 5.09
  - 96
• Japan 2.04 - 385 1.86
  -419
• Source The Economist.com

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Concluding Statement

• Uncertainty is the central problem confronting
  financial markets.
• Mr. Jacob Frenkl
• Chairman, Merrill Lynch International
• September 2002
• The only certainty in financial
• markets is uncertainty
• Credit Swiss, August 16, 2007