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FNCE 4070: FINANCIAL MARKETS

AND INSTITUTIONS
Lecture 2: Frameworks for Understanding
Financial Markets and Institutions

Functions of a Financial
Market.
Classifications of Financial
Markets and Financial Assets.
Major Issues Facing Financial
Market Participants.
Financial Market Signals.
Who are These Central Bankers and
Where are their Central Banks?
Who are These Central Bankers and
Where are Their Central Banks?
Federal Reserve (1913)
Washington, DC
Fed funds rate: 0.0 – 0.25;
Inflation target: 2% (2.3%)

Bank of England (1694)


London, U.K.
Bank Rate: 0.5%; Inflation target:
Sir Mervyn King 2% (3%)
Ben Bernanke
Bank of Japan (1882)
Masaaki Shirakawa Tokyo, Japan
Uncollateralized Overnight Call
Rate: 0 - 0.1%; Inflation Target
1% (0.4%)

European Central Bank (1998)


Frankfurt, Germany
Main Refinancing Rate: 2%;
Inflation Target: “Below, but close
Mario Draghi to 2%” (2.4%)
Financial Markets and Financial
Institutions
 How might we study these?
 Perhaps in terms of specific functions?
 What are functions of financial markets and financial
institutions?
 Perhaps in terms of organizations and institutions
that participate in financial markets
 Commercial organizations (commercial banks, investment
banks, pension funds, mutual funds, financial service
providers, etc.).
 Governmental organizations (Central banks, regulatory
organizations --- SEC; FSA)
 Private credit ratings organizations (S&P, Moody’s, Fitch)
Function of Financial
Markets
 Typical text book definition: “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, Treasury securities,
commercial paper market.
Functions of Financial
Markets
 Mechanism for raising funds!
 Done in primary financial markets (e.g.,
IPOs --Facebook) with the assistance of
investment banking firms.
 Mechanism for converting financial assets
into cash before maturity.
 Done in secondary financial markets
(e.g., NYSE, OTC bond markets)
Functions of Financial Markets
 Provides the means for entities to protect
(hedge) their financial/commercial
positions.
 Done in derivatives markets

(options, futures, forwards, credit default


swaps)
 Mechanism for generating a return on
surplus funds (Investing).
 Return occurs through interest,
dividends, capital appreciation
Functions of Financial
Markets
 Allocates “limited” 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!
Functions of Financial Markets
 Provides financial signals to market participants
 Interest rates, stock prices, exchange rates as
measures of market’s perception of risk and changing
risk assessments:
 Stock prices and interest rates may tell us something about
the market’s assessment of companies, financial institutions,
and even overall financial markets: 2008 credit crisis.
 Exchange rates and government interest rate spreads may
tell us something about the market’s assessment of
countries or regions): 2010 – 2012 Crisis in the Euro-zone.
 Perhaps we can use financial market signals as a
leading indicator of economic activity.
 Yield curves, stock prices, central bank rates
Classification of Financial Markets
 Primary Financial Market
 The financial market in which new issues of a security, such as a
bond or a stock, are sold to initial buyers by a corporation or a
government.
 Important financial institution that assists in the initial sale of securities in
the primary market are investment banks. They do this by “underwriting
securities,” i.e., (usually) guaranteeing a price for a corporation’s
securities and then selling them to the public (an IPO).
 Thus, primary financial markets are important for raising new
capital.
 Secondary Financial Market
 The financial market in which securities that have been
previously issued can be resold. The New York Stock Exchange
(NYSE) and National Association of Securities Dealers
Automated Quotation System (NASDAQ) are examples for
secondary markets.
 Secondary markets provide liquidity for previously issued securities:
 Liquidity refers to the ease of conversion of a financial asset into cash (prior to
maturity if there is a maturity date) and how stable the price of the asset is
while being held in a form other than cash.
Classification
Money Markets
of Financial Markets
 The financial markets for short-term debt instruments (generally those
with original maturity of one year or less). As we will see, shorter term
securities have smaller fluctuations in prices than long-term securities,
making them “safer” to invest as well as highly liquid.
 Commercial banks use Treasury bills for their “secondary reserves” to meet
deposit withdrawals and increases in loan demands.
 Corporations and banks use the money market to earn interest on
surplus working capital and to finance working capital shortages.
Institutions, such as money market mutual funds, specialize in acquiring
these assets.
 Money market instruments include: U.S Treasury bills, Commercial
Paper, Bank Certificates of Deposit, and Bankers’ Acceptances.
 Capital Markets
 The financial market for longer-term debt (generally those with maturities
greater than one year) and equity (common stock).
 Long term securities are often held by financial intermediaries such as
insurance companies and pension funds, which have less uncertainty
about the amount of funds they will need in the future.
 These assets are also less liquid (in terms of price stability) than money market
instruments.
 Capital market instruments include: Common Stock, U.S Treasury
bonds, Corporate bonds, and Mortgages
Flow of Funds Through a Financial
System
 Indirect Finance:
 Funds that flow through financial intermediaries, such
as depository institutions, insurance companies and
mutual funds. These institutions work as a channel of
indirect financing by pooling saver funds then invest
(or lending) those funds through to businesses and
others that need them.
 Direct Finance:
 Funds that flow directly lenders to borrowers with the
assistance of institutions that provide brokerage
services (research and advice, retirement planning,
tax tips, execution of trades) . These institutions work
as a channel of direct financing, in which businesses
and governments can raise funds directly from lenders
in financial markets (IPOs).
Flow of Funds Through a Financial
System
Why are Financial Intermediaries
Important in Financial Markets?
 Transaction cost: Refers to the time and money spent in carrying out
financial transactions. Financial intermediaries can substantially reduce
transaction costs because they have developed expertise in lowering them,
and because their large size allows them to take advantage of economies of
scale.
 Risk sharing: Financial intermediaries sell assets with risk characteristics
that people are comfortable with and then use the funds to purchase other
assets that may have far more risk. This process of risk sharing is called
asset transformation; i.e., risky assets are turned into safer assets for
investors. Another way of risk sharing provided was through diversification;
financial intermediaries invest in a collection of assets whose return do not
always move together, with the result that overall risk is lower than for
individual assets.
 Asymmetric information (i.e., where one party has more or better
information): Financial intermediaries are usually better at credit risk
screening than individuals, therefore reducing losses due to wrong
investment decision making. They have developed expertise in monitoring
the parties they lend to, thus reducing losses due to moral hazard.
 Moral hazard: The tendency to take on more risk because of the perception that
one is protected from the consequences of doing so.
Classification of Financial Assets
 (1) Financial assets which represent a claim on
the issuer’s future income and/or assets.
Examples include:
 Bonds: Debt instruments with a contractual
agreement (indenture specifies interest payment,
maturity date, etc.).
 Common Stocks: Instruments representing an
ownership position in a corporation (note this does
not represent a “legal” claim such as a bond).
 (2) Instruments which are neither debt nor equity
based and thus belong in their own category.
 Foreign Exchange
Classifications of Financial Assets
 Cash instruments are financial assets whose
value is determined directly by financial markets.
 Stock and bonds

 Derivative instruments are financial assets


which derive their value from some other
(underlying) financial instrument (i.e., called the
underlying asset) or variable.
 Futures, forwards, options (puts and calls)
 This market originated in Chicago in the 1850s
(CBOT) for commodities (flour, hay, corn), but
now involves financial assets as well.
Characteristics of a Well Functioning
Financial Market
 (1) Transparency:
 Condition whereby all participants will have
access to reliable and important information at the
same time.
 Importance of financial services providers to
transparency in disseminating financial information.
 Dow Jones, Bloomberg, Reuters.
 Importance of reliable accounting data.
 Importance of trading platforms to transparency.
 How quickly is trading information made available?
 Do all potential traders have access to same trading
information (bid and ask prices publicly displayed).
Well Functioning Financial Market
 (2) Adequate Regulation:
 Financial markets need to have regulation which
ensures a level and fair playing field and appropriate
behavior.
 Regulation needs to:
 Encourage quick and full disclosure
 Provide appropriate reporting of financial information to markets
 Discourage unethical behavior: insider trading, price
manipulations.
 Issue for regulators:
 A what point does regulation become a burden (excessive)
and/or drive financial service providers to other markets?
 Perhaps regulators need to use a cost – benefit analysis
approach.
 Beginning with the Great Depression of the 1930s, the
U.S. has gone through a series of financial market
regulatory changes.
Real GDP and Inflation During the
Great Depression
Real GDP (1929 = 100) CPI, % Change, YonY
The Unemployment Rate and Bank
Failures During the Great Depression
U.S. Unemployment Rate Number of Banks (1,000’s)
U.S. Financial Market Regulation: the
Aftermath of the Great Depression
 The Policy Responses to the Great Depression
 Over 10,000 banks failed during the Great Depression which began
in October 1929 and continuing until March 1933. Government policy
makers believed the collapse of the financial system contributed to
the length and depth of the recession.
 In February 1932, Congress passed the Banking Act of 1932.
Senator Carter Glass and Representative Henry Steagall coauthored
the legislation, which became known as the Glass-Steagall Act.
 The Glass-Steagall Act contained several provisions which shaped
the financial landscape in the United States for about 50 years.
 (1) The act established nationwide deposit insurance.
 (2) The act separated commercial from investment banking. The
act required commercial banks to sell their securities affiliates
within one year.
 (3) The Act prohibited banks from paying interest on demand
deposits.
U.S. Financial Market Regulation:
In the 1930s
 Another series of acts in response to the Great Depression
regulated stock exchanges and securities markets.
 In 1933, Congress passed the Securities Act, which established
federal regulation of securities issues. In 1934, Congress passed
the Securities Exchange Act which established the Securities and
Exchange Commission (SEC) to regulate the issuance,
purchase, and sale of securities, particularly equities and debt
instruments. The act required all public companies to submit
periodic financial statements under penalty of perjury.
 Securities and Exchange Act of 1934 also made it unlawful for any
person "to use or employ, in connection with the purchase or sale of any
security… any manipulative or deceptive device” (including insider
trading).
 In 1936, Congress passed the Commodities Exchange Act which
required all commodities futures and options to be traded on
organized exchanges.
Pressure to Loosen U.S. Financial
Market Regulation: 1980s and 1990s
 Financial markets operated calmly from the 1940s to
the early 1980s. However, During the 1980s and
1990s, the structure of financial regulation in the
United States changed dramatically.
 Impetus for change came from three directions.
 (1) First, free-market thinking increasingly prevailed in policy
debates.
 (2) Second, globalization forced financial institutions in the United
States to compete in ever more competitive international markets
against institutions operating in more permissive regulatory
environments. U.S. institutions incessantly lobbied to loosen
regulations and level the playing field.
 (3) Third, during the 1970s, the S&L industry collapsed.
 Policy makers felt the S&L failure had resulted, in part, from over-
regulation, specifically limiting the interest rate (at 6%) which
these institutions could offer on their deposit accounts. When
interest rates rose above 6% these institutions became insolvent.
Shift to Regulation in the 1980s and
1990s
 Changes in regulations in the 1980s and 1990s
tended reduced restrictions on the operations of
financial institutions, allowing them to enter new
lines of business.
 Since the Banking Act of 1932, banks were prevented from
engaging in “universal banking,” or banking in both
commercial and investment industries. The passage of the
Gramm-Leach-Bliley Act of 1999 removed the barriers
between the banking sectors of commercial, investment,
and insurance, effectively overturning the Glass-Steagall
Act.
 Additional acts phased in the paying of interest on checking
accounts and eliminated any interest rate ceilings on
savings and time deposits.
Response to Corporate Abuse:
Passage of SOX in 2002
 The Public Company Accounting Reform and Investor Protection
Act of 2002, more commonly referred to as Sarbanes-Oxley
(SOX), was passed in July 2002 after several prominent
companies were involved in financial scandals and bankruptcies:
Enron, Worldcom, Xerox, Sunbeam, Waste Management,
Adelphia, Tyco, HealthSouth, Global Crossing, and others”
 SOX contains three main components.
 First, in an attempt to provide market participants with access to identical
information and a level playing field, SOX “forbids preferential
disclosures to market analysts.”
 Second, in an attempt to create accountability and monitoring within
corporations, SOX requires the CEO and CFO of all publicly traded
corporations to sign the financial statements that they submit to the SEC,
opening them up to criminal penalties for perjury should the forms prove
fraudulent. In addition, SOX requires publicly traded companies have an
independent board of directors.
 Third, SOX mandated “more monitoring by accountants, in addition to
monitoring by independent directors.
Response to 2007-09 Financial
Crisis: Passage: Dodd-Frank in 2010
 The Dodd-Frank Wall Street Reform and Consumer Protection Act,
commonly known as Dodd-Frank, is comprised of several unrelated
regulations. The Act passed in July 2010 in response to the 2007 –
2009 financial crisis.
 One prominent aspect of Dodd-Frank is the Volcker Rule (named after
the former Federal Reserve chairman who proposed it). While it is still
in the discussion stage, the essential elements are as follows:
 The Volcker rule is an attempt to separate investment banking, private equity and
proprietary trading (hedge fund) sections of financial institutions from their
consumer lending arms.
 The Volcker rule would restrict the ability of banks whose deposits are federally
insured from trading for their own benefit by prohibiting an insured depository
institution and its affiliates from: engaging in “proprietary trading”; acquiring or
retaining any equity, partnership, or other ownership interest in a hedge fund or
private equity fund; and sponsoring a hedge fund or a private equity fund.
 The Volcker rule would ban banks from making speculative bets with firm money,
but includes an exemption for trades done to hedge risk.
 In essence, the rule would return some restrictions on proprietary trading by
commercial banks that were lifted when the Glass-Steagall Act was rescinded.
Well Functioning Financial Market
 (3) Competition:
 Markets need to be structured and regulated so as to
offer easy access and exit.
 Not segmenting financial service providers.
 Not overly protecting (or rescuing) poorly run firms.
 Moral hazard issue (“too big to fail” or government guarantees).
 Competition applies to both domestic and foreign
entities.
 Goal: To ensure best prices and services for end users.
 (4) 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.
Major Issue Facing Participants in
Financial Markets
 Are the prices of financial instruments
potentially unstable? How volatile are they?
Are they subject to?
 Quick and large short term moves.
 Substantial longer term trend changes
 Quick answer: YES!!!
 Volatility is one major issue facing
participants in financial markets.
Interest Rates
Annual Data YoY
Corporate AAA Total Return
Changes in Stock Prices
Annual Data YoY
Changes in Exchange Rates
Annual Data (YoY)
Impact of Changes in Financial Variables
 Changes in interest rates:
 Affect the cost of borrowing (end users and intermediaries)
 Influence the returns (and profit margins) to interest sensitive
financial institutions (e.g., banks) and the borrowings/investments
of non-financial sectors (household and companies).
 Affect asset prices (bonds, stocks, foreign exchange).
 Impact on the M&A market (leveraging activities)
 Impact on mortgage markets.
 Changes in stock prices:
 Affect the economy’s perception of wealth:
 Influence spending decisions (through the “wealth effect”).
 Affect the IPO market and M&A market (P/E multiples)
 Changes in exchange rates:
 Affect the competitive position of global firms, exporters and
importers.
 Affect the returns to global investment funds (mutual funds, pension
funds).
Signals from the Stock Market
 Forecasters have noted
that for the U.S., investors
start discounting the end
of an expansion and the
beginning of a recovery in
advance of the business
cycle turning point.
 Study by Jeremy Siegel:
 38 of the 41 U.S. recessions (or
93%) over the period1802 to
1990 have be preceded by an
8% decline in the stock market.
 The S&P 500 is one of the 10
measures in the Conference
Board’s monthly Leading
Indicator Index for the U.S.
 http://www.conference-
board.org/data/bcicountry.cfm?c
id=1
Stock Market as a Leading Indicator:
1968-1983
Stock Market as a Leading Indicator:
1989-1992
Stock Market as a Leading Indicator:
1997-2011
Appendix 1

Useful Websites for Stock Prices


and Exchange Rates
Stock Prices

 For long term historical views go to:


 http://moneycentral.msn.com/investor/charts/
chartdl.aspx?Symbol=%24INDU&CP=0&PT=
5

 For a view of what’s happening now go to:


 http://bloomberg.com/
 Or:
 http://finance.yahoo.com/marketupdate?u
Exchange Rates

 Go to:
 http://fx.sauder.ubc.ca/
 http://www.fxstreet.com/