1
Finance School of Management
Chapter 2,The Financial
System
Objective
?Understanding the workings of
the financial system
?Determining rates
of return
2
Finance School of Management
Chapter 2 Contents
? What is a Financial
System
? The Flow of Funds
? The Functional
Perspective
? Financial Innovation &
the,Invisible Hand”
? Financial Markets
? Financial Market Rates
? Financial Intermediaries
? Financial Infrastructure
and Regulation
? Governmental & Quasi-
Governmental
Organizations
3
Finance School of Management
What is the Financial System?
?The financial system encompasses
– markets
– Intermediaries
– other institutions
used to carry out the financial decisions of
households,business firms,and
governments,
4
Finance School of Management
? Exchanges & over-the-counter (OTC,off-exchange)
markets
? Financial intermediaries
– providing financial services and products
– banks,investment companies,and insurance companies
– checking accounts,commercial loans,mortgages,mutual
funds,insurance contracts and many other contracts
? Financial markets and intermediaries are
– linked through networks and global in scope
– governed by the regulatory institutions
What is the Financial System?
5
Finance School of Management
The Flow of Funds
Markets
Intermediaries
Surplus Units Deficit Units
6
Finance School of Management
Fund Flows via Market
Intermediaries
broker
Markets
Surplus Units Deficit Units
A household buys shares
of stocks from a firm
Dividend
reinvestment plans
7
Finance School of Management
Fund Flows via Intermediary
Markets
Intermediaries
Surplus Units Deficit Units
Savings at a bank
A loan to a firm
8
Finance School of Management
Fund Flows via Intermediary and Market
Markets
Intermediaries
Surplus Units Deficit Units
An insurance
account
9
Finance School of Management
Fund Flows via Markets and Intermediaries
Markets
Intermediaries
Surplus Units Deficit Units
A finance company
making loans to
households
10
Finance School of Management
Funds Flow,Disintermediation
Markets
Intermediaries
Surplus Units Deficit Units
Markets
Intermediaries
Surp us nits efi t nits
11
Finance School of Management
Funds Flow,Secured Credit
Markets
Intermediaries
Surplus Units Deficit Units
Poor Credit Risk
12
Finance School of Management
The Functional Perspective on
Financial System
?Financial institutions generally differ across
borders and also change over time,
?The functional perspective
– Financial functions are more stable than
financial institutions,
– Institutional form follows function,
?The primary function of financial system is
efficient resource allocation,
13
Finance School of Management
Six Key Financial Functions
– Transferring Resources across Time & Space
– Managing Risk
– Clearing and Settling Payments
– Pooling Resources and Subdividing Shares
– Providing Information
– Dealing with the Incentive Problems
14
Finance School of Management
Transferring Resources across Time & Space
? To facilitate intertemporal transfers of resources
– Student loans
– Venture capitals
? To play an important role in shifting resources from
one place to another
– The transfer of underused capital from Germany to
Russia
– The retirement savings of Japanese workers to be used to
finance the house purchased by a young couple in the
United States
15
Finance School of Management
Quick Check
? Give an example of a transfer of resources over
time that takes place through the financial
system,
? Is there a more efficient way for this transfer of
resources to be handled?
16
Finance School of Management
Managing Risk
? Transfers of risks through financial system
– Insurance policies
? The flow of funds bundled with the flow of risks
– Finance $100,000 to start a business
– $70,000 from an investor,in equity capital in return for a
75% share of the profits
– $30,000 from a bank,at an interest rate of 6% per year
? The flow of funds unbundled with the flow of risks
– A guaranteed loan
17
Finance School of Management
Quick Check
? Give an example of a transfer of risk that takes
place through the financial system,
18
Finance School of Management
Clearing and Settling Payments
? A financial system provides an efficient payments
system to facilitate the exchange of goods,services,
and assets,
– Traveling abroad
– The development of checks,credit cards,and electronic
funds transfer
19
Finance School of Management
Pooling Resources and Subdividing Shares
? A variety of mechanisms to pool or aggregate the
wealth of households into large masses of capital
? Opportunities for individual households to
participate in investments that require large lump
sums of money by pooling their funds and then
subdividing shares in the investment
– You,having only $10,000,want to invest in a race horse
that costs $100,000,
– Investing in U.S.Treasure bills with the minimum
denomination of $10,000 and money-market funds,
20
Finance School of Management
Providing Information
? Price information that helps coordinate decentralized
decision-making in various sectors of the economy
– You are 30 years old,just got married,and want to buy a
house for $100,000,
– Your local bank will make you a mortgage loan for $80,000
at an interest rate of 8% per year,but you need to pay 20%
down,
– Your 45-year-old sister has a savings account with $20,000
in it for her retirement,earning 6% per year,
– If your sister is willing to lend you her retirement savings
for your down payment,how do you decide what a,fair”
rate of interest rate?
21
Finance School of Management
Providing Information
– A firm,earning $10 million in profits in a good year,is
faced with deciding whether to reinvest it in the business,
pay it out in cash dividends to shareholders,or use it to buy
back its own shares,
? Whenever a new financial instrument is introduced,
new possibilities for information extraction are
created as a ―by-product‖,
– The trading of option contracts & the information about the
volatilities of financial markets
22
Finance School of Management
Incentive Problems
? Incentive Problems may arise when one party to a
financial transaction has information that the other
party does not,or when one party is an agent that
makes decisions for another,
? Incentive Problems limit the ability of a financial
system to perform some of the functions,
23
Finance School of Management
The Moral-Hazard Problem
? The problem exists when having insurance against
some risk causes the insured party to take greater
risk or to take less care in preventing the event that
gives rise to the loss,
– Fire insurance for a warehouse
– Asymmetry information & financing business ventures
24
Finance School of Management
Quick Check
? Give an example of how the problem of moral
hazard might prevent you from getting
financing for something you want to do,Can
you think of a way of overcoming the problem?
25
Finance School of Management
The Adverse Selection Problem
? The problem exists when those who purchase
insurance against risk are more likely than the
general population to be at risk,
– Life annuities
– Car leasing
26
Finance School of Management
Quick Check
? Suppose a bank offered to make loans to
potential borrowers without checking their
credit history,What would the true of the types
of borrowers they would attract compared to
banks that did checks of credit history? Would
such a bank charge the same interest rate on
loans as banks that check credit history?
27
Finance School of Management
The Principal-Agent Problem
? The problem arises when those who bear the risks
associated with the decisions (the principals) delegate the
decision-making authority to others (the agents),
– Shareholders in a corporation delegate the running of the firm
to its managers
– Investors in a mutual fund delegate the authority to select the
mix of their security holdings to a portfolio manager
? Agents may not make the same decisions that the
principals would have made if they knew what the agents
know and were making the decisions themselves,
28
Finance School of Management
? A well-functioning financial system facilitates the
resolution of the incentive problems,
– Collateralization of loans
– Performance-based compensation of management
– Takeovers
– Conflicts of interest between shareholders and creditors,
“equity-kickers”
Dealing with Incentive Problems
29
Finance School of Management
Financial Innovation and the ―Invisible Hand‖
?Financial innovations are not planned by any
central authority but arise from the individual
actions of entrepreneurs and firms,
?Adam Smith’s observation,
In a competitive market economy,by
pursuing one’s own interest one frequently
promotes that of society more effectually
than when one really intends to promote it,
30
Finance School of Management
Financial Innovation and the ―Invisible Hand‖
? An Illustration,Credit Card Business
? Another Illustration,Mortgages & securitization
? Financial innovations have greatly improved the
opportunities for people to receive efficient risk-
return trade-offs in their personal investments and
more effective tailoring to their individual needs over
the entire life cycle,
? Analysis of consumer preferences and the forces of
competition among financial-service providers helps
one to make predictions about future changes in the
financial system,
31
Finance School of Management
Financial Markets
? Basic types of financial assets
– Debt (fixed-income instruments)
– Equity (the claim of the owners of a firm,residual claim,
limited liability)
– Derivatives (their value derived from the prices of other
assets,options and forward contracts)
? Classification by the maturity
– Money market (for short term debt,less than one year,
globally integrated and liquid)
– Capital market (long term debt and equity securities)
32
Finance School of Management
Fixed-income Claim Residual Claim
Markets Classified by Assets
33
Finance School of Management
Fixed-income Claim Residual Claim
Liability
Instrument
Preferred Stock Common Stock
Markets Classified by Assets
34
Finance School of Management
Fixed-income Claim Residual Claim
Liability
Instrument
Preferred Stock Common Stock
Fixed-income
Security Market Stock Market
Bond Market Common Stock Market
Markets Classified by Assets
35
Finance School of Management
Debt instrument Preferred Stock and Common Stock
Markets Classified by Maturity
36
Finance School of Management
Maturity
Less Than 1 Year
Debt instrument Preferred Stock and Common Stock
Maturity
More Than 1 Year
Markets Classified by Maturity
37
Finance School of Management
Markets Classified by Maturity
Money
Market
Capital
Market
Maturity
Less Than 1 Year
Debt instrument Preferred Stock and Common Stock
Maturity
More Than 1 Year
38
Finance School of Management
Derivatives Instruments Markets
Derivatives Instruments
Forward Contracts Market Options Market
39
Finance School of Management
Interest Rates
? Financial prices and financial market indicators
? An interest rate is a promised rate of return on a
fixed-income instrument and depends on the three
important factors,
– Unit of account
– Maturity
– Default risk
? A variety of interest rates
– commercial loan rate,mortgage rate
40
Finance School of Management
Effect of Unit of Account,An Illustration
15000 ￥
15260 ￥
15450 ￥
￡100
￡109
Time
3% ￥/￥ (direct)
1.73% ￥/￡/￡/￥
150 ￥/￡
9%￡/￡
140 ￥/￡
Japan U.K,
41
Finance School of Management
15000 ￥
16241 ￥
15450 ￥
￡100
￡109
Time
3% ￥/￥ (direct)
8.27% ￥/￡/￡/￥
150 ￥/￡
9%￡/￡
149 ￥/￡
Japan U.K,
Effect of Unit of Account,An Illustration
42
Finance School of Management
15000 ￥
(borrowed)
15450 ￥
15450 ￥
Repaid
￡100
Invested
￡109
Matures
Time
3% ￥/￥ (direct)
3% ￥/￡/￡/￥
150 ￥/￡
9%￡/￡
Forward ￥/￡
Japan U.K,
Effect of Unit of Account,An Illustration
43
Finance School of Management
Effect of Maturity
US Treasury Yield Curve,Jan 97
4.50
5.00
5.50
6.00
6.50
7.00
7.50
0 5 10 15 20 25 30
Years to Maturity
An
nu
ali
ze
d
Yie
ld
(%
)
44
Finance School of Management
Effect of Default Risk,Yield Comparisons
A p r i l ' 9 5 US C o r p o r a t e C o r p o r a t e
Tr e a s u r y H i g h Q u a l i t y M e d Q u a l i t y
1 - 1 0 Y e a r s 6, 9 2 % 7, 5 7 % 7, 8 6 %
1 0 + + Y e a r s 7, 6 5 % 8, 1 5 % 8, 5 5 %
45
Finance School of Management
Rates of Return on Risky Assets
%1010.0
1 0 0$
5$)1 0 0$1 0 5($
)(
??
??
?
??
?
R e t u r n
S t a r t P r i c e
ndC a s h D i v i d eS t a r t P r i c eE n d P r i c e
R e t u r n
Capital
gain or
loss
Dividend
payments
46
Finance School of Management
Market Indexes and Market Indexing
?Indexes is a measure of the overall level of
stock prices,
– Somebody might want a indicator or
benchmark against which to measure the value
or performance of their investment,
47
Finance School of Management
? Indexing is an investment approach
– that seeks to match the investment returns of a
specified stock-market index by holding all or a
representative sample in the case of very large index
(replicate),
– emphasizing broad diversification and low portfolio
trading activity (cost advantage and,passive”
investment strategy),
– It is impossible for all stock investors in the
aggregate to outperform the overall stock market,
Market Indexes and Market Indexing
48
Finance School of Management
S e c u r i t y R e t u r n s
- 6 0, 0 0
- 4 0, 0 0
- 2 0, 0 0
0, 0 0
2 0, 0 0
4 0, 0 0
6 0, 0 0
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Y e a r
%
R
e
t
u
r
n
B i l l s
B o n d s
S t o c k s
I n f l a t i o n
49
Finance School of Management
C o n s o l i d a t e d I n d i c i e s
1, 0 0 0 0
1 0, 0 0 0 0
1 0 0, 0 0 0 0
1 0 0 0, 0 0 0 0
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Y e a r
I
n
d
e
x
(
L
o
g
S
c
a
l
e
)
B i l l s _ I n d e x
B o n d s _ I n d e x
S t o c k s _ I n d e x
I n f l a t i o n _ I n d e x
50
Finance School of Management
F r e q u e n c y o f R e t u r n s
0
10
20
30
40
50
60
70
- 5 0 - 4 0 - 3 0 - 2 0 - 1 0 0 10 20 30 40 50
P e r c e n t
P
r
o
b
a
b
i
l
i
t
y
F r e q _ B i l l s
F r e q _ B o n d s
F r e q _ S t o c k
F r e q _ I n f l a t i o n
51
Finance School of Management
Inflation and Real Interest Rates
? The nominal interest rate on a bond is the
promised amount of money you receive per unit
you lend,
? The real rate of return is defined as the nominal
interest rate you earn corrected for the change in
the purchasing power of money,
? National Consumer Price Index (CPI)—the unit of
account for computing the real rate of return
52
Finance School of Management
Nominal to Real
a t eI n f l a t i o n R
a t eI n f l a t i o n ReN o m i n a l R a t
R e a l R a t e
a t eI n f l a t i o n RR e a l R a t eeN o m i n a l R a t
?
?
?
?
????
1
)1(*)1()1(
53
Finance School of Management
The Value of an Investment of $1 in 1926
with Reinvestment,US Markets
Source,Ibbotson Associates
0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
Log
sc
ale
Year End
1
5520
1828
55.38
39.07
14.25
Nominal Dollars
54
Finance School of Management 0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
Source,Ibbotson Associates
Log
Sc
ale
Year End
1
613
203
6.15
4.34
1.58
Real Dollars
The Value of an Investment of $1 in 1926
with Reinvestment,US Markets
55
Finance School of Management
Interest Rate Equalization
?Competition in financial markets ensures that
interest rates on equivalent assets are the
same,
?If the same terms (e.g.,maturity,default risk)
can be borrowed and lent on at different
interest rates,then interest-rate arbitrage can
be carried out,
56
Finance School of Management
Quick Check
? Suppose you have $10,000 in a bank account
earning an interest rate of 3%,At the same time
you have an unpaid balance on your credit card
of $5,000 on which you are paying an interest
rate of 17% per year,What is the arbitrage
opportunity you face?
57
Finance School of Management
The Fundamental Determinants of Rates of Return
? There are four main factors that determine rates of
return in a market economy,
– the expected productivity of capital goods
– the degree of uncertainty about the productivity of
capital goods
– time preference of people
– risk aversion
58
Finance School of Management
Finance Intermediaries
?Financial intermediaries are firms whose
primary business is to provide products that
cannot be obtained more efficiently by
transacting directly in securities markets,
59
Finance School of Management
? Clearing and settling payments,money-changers
? Taking deposits and make loans,commercial
banks
? All-purpose financial intermediaries,universal
banks
Banks
60
Finance School of Management
? Thrift institutions,savings banks,savings and
loan associations (S&Ls),credit unions
? In U.S.,thrifts
– Competing with commercial banks
– Specializing in marking home mortgage and
consumer loans
Other Depository Savings Institutions
61
Finance School of Management
? To allow households and businesses to shed specific
risks by buying insurance policies that pay cash
compensation if certain specified events occur,
– premiums
– Property and casualty insurance,covering accidents,
theft or fire
– Health and disability insurance,covering sickness or
inability to work
– Life insurance,covering death
Insurance Companies
62
Finance School of Management
? To replace a person’s pre-retirement earnings when
combined with Social Security retirement benefits
and private savings,
– Defined-contribution pension plan
– Defined-benefit pension plan
Pension and Retirement Funds
63
Finance School of Management
?A portfolio of stocks,bonds,or other assets
purchased in the name of a group of investors
and managed by a professional investment
company or other financial institution,
– Divisibility,record keeping,reinvestment of
receipts,efficient diversification
– Open-end mutual funds and NAV (net asset
value)
– Close-end mutual funds
Mutual Funds
64
Finance School of Management
? To help business,governments,and other entities
raise funds to finance their activities by issuing
securities,
? To facilitate and sometimes initiate mergers of firms
or acquisitions of one firm by another,
– Underwriting,committing to buy the securities at a
guaranteed future price
– Glass Steagall Act of 1933
Investment Banks
65
Finance School of Management
? To provide both financing and advices in running
the business of startup firms with inexperienced
managers,
–,go public” and exit
Venture Capital Firms
66
Finance School of Management
? Advising and administering mutual funds,pension
funds,and other asset pools for individuals,firms,
and governments,
Asset Management Firms
67
Finance School of Management
? Many financial service firms provide information as
a by-product of their main activities,but there are
firms that specialize in providing information,
– Rating agencies,Moody’s and Standard & Poor’s for
the securities business,Best’s for the insurance
industry
– Analysis of financial data,Bloomberg and Reuters
– Performance statistics on mutual funds,Lipper,
Morningstar,and SEI
Information Services
68
Finance School of Management
Financial Infrastructure and Regulation
? Financial infrastructure consists of
– legal and accounting procedures
– the organization of trading and clearing facilities
– the regulatory structure that govern the relations among the
users of the financial system
? Rules for trading
– To serve the function of standardizing procedures so that
the costs of transacting are kept to a minimum
? Accounting systems
– To present financial information in a standard format
69
Finance School of Management
Governmental & Quasi-Governmental
Organizations
? Central Banks
– To promote public policy objectives by influencing
certain market parameters such as the supply of the
local currency,
– The People’s Bank of China,Federal Reserve System,
the Bank of England….,
– At the heart of a country’s payments system,the supply
of local currency and the clearing system for the banks,
70
Finance School of Management
Governmental & Quasi-Governmental
Organizations
? Special-Purpose Intermediaries
– To encourage specific economic activities by making
financing more readily available or by guaranteeing
debt instruments of various sorts,
– To insure bank deposits,to promote economic stability
by preventing a breakdown in part or all of the financial
system,
71
Finance School of Management
Governmental & Quasi-Governmental Organizations
? Regional and World Organizations
– Bank for International Settlements (BIS) in Basle,Switzerland,to
promote uniformity of banking regulations
– International Monetary Fund (IMF)
? monitoring economic and financial conditions in member countries,
? providing technical assistance,
? establishing rules for international trade and finance,
? providing a forum for international consultation,and most
importantly,
? providing resources that permit lengthening the time necessary for
individual members to correct,imbalances” in their payments to
other countries
– World Bank,to finance investment projects in developing countries by
selling bonds in developed countries
Finance School of Management
Chapter 2,The Financial
System
Objective
?Understanding the workings of
the financial system
?Determining rates
of return
2
Finance School of Management
Chapter 2 Contents
? What is a Financial
System
? The Flow of Funds
? The Functional
Perspective
? Financial Innovation &
the,Invisible Hand”
? Financial Markets
? Financial Market Rates
? Financial Intermediaries
? Financial Infrastructure
and Regulation
? Governmental & Quasi-
Governmental
Organizations
3
Finance School of Management
What is the Financial System?
?The financial system encompasses
– markets
– Intermediaries
– other institutions
used to carry out the financial decisions of
households,business firms,and
governments,
4
Finance School of Management
? Exchanges & over-the-counter (OTC,off-exchange)
markets
? Financial intermediaries
– providing financial services and products
– banks,investment companies,and insurance companies
– checking accounts,commercial loans,mortgages,mutual
funds,insurance contracts and many other contracts
? Financial markets and intermediaries are
– linked through networks and global in scope
– governed by the regulatory institutions
What is the Financial System?
5
Finance School of Management
The Flow of Funds
Markets
Intermediaries
Surplus Units Deficit Units
6
Finance School of Management
Fund Flows via Market
Intermediaries
broker
Markets
Surplus Units Deficit Units
A household buys shares
of stocks from a firm
Dividend
reinvestment plans
7
Finance School of Management
Fund Flows via Intermediary
Markets
Intermediaries
Surplus Units Deficit Units
Savings at a bank
A loan to a firm
8
Finance School of Management
Fund Flows via Intermediary and Market
Markets
Intermediaries
Surplus Units Deficit Units
An insurance
account
9
Finance School of Management
Fund Flows via Markets and Intermediaries
Markets
Intermediaries
Surplus Units Deficit Units
A finance company
making loans to
households
10
Finance School of Management
Funds Flow,Disintermediation
Markets
Intermediaries
Surplus Units Deficit Units
Markets
Intermediaries
Surp us nits efi t nits
11
Finance School of Management
Funds Flow,Secured Credit
Markets
Intermediaries
Surplus Units Deficit Units
Poor Credit Risk
12
Finance School of Management
The Functional Perspective on
Financial System
?Financial institutions generally differ across
borders and also change over time,
?The functional perspective
– Financial functions are more stable than
financial institutions,
– Institutional form follows function,
?The primary function of financial system is
efficient resource allocation,
13
Finance School of Management
Six Key Financial Functions
– Transferring Resources across Time & Space
– Managing Risk
– Clearing and Settling Payments
– Pooling Resources and Subdividing Shares
– Providing Information
– Dealing with the Incentive Problems
14
Finance School of Management
Transferring Resources across Time & Space
? To facilitate intertemporal transfers of resources
– Student loans
– Venture capitals
? To play an important role in shifting resources from
one place to another
– The transfer of underused capital from Germany to
Russia
– The retirement savings of Japanese workers to be used to
finance the house purchased by a young couple in the
United States
15
Finance School of Management
Quick Check
? Give an example of a transfer of resources over
time that takes place through the financial
system,
? Is there a more efficient way for this transfer of
resources to be handled?
16
Finance School of Management
Managing Risk
? Transfers of risks through financial system
– Insurance policies
? The flow of funds bundled with the flow of risks
– Finance $100,000 to start a business
– $70,000 from an investor,in equity capital in return for a
75% share of the profits
– $30,000 from a bank,at an interest rate of 6% per year
? The flow of funds unbundled with the flow of risks
– A guaranteed loan
17
Finance School of Management
Quick Check
? Give an example of a transfer of risk that takes
place through the financial system,
18
Finance School of Management
Clearing and Settling Payments
? A financial system provides an efficient payments
system to facilitate the exchange of goods,services,
and assets,
– Traveling abroad
– The development of checks,credit cards,and electronic
funds transfer
19
Finance School of Management
Pooling Resources and Subdividing Shares
? A variety of mechanisms to pool or aggregate the
wealth of households into large masses of capital
? Opportunities for individual households to
participate in investments that require large lump
sums of money by pooling their funds and then
subdividing shares in the investment
– You,having only $10,000,want to invest in a race horse
that costs $100,000,
– Investing in U.S.Treasure bills with the minimum
denomination of $10,000 and money-market funds,
20
Finance School of Management
Providing Information
? Price information that helps coordinate decentralized
decision-making in various sectors of the economy
– You are 30 years old,just got married,and want to buy a
house for $100,000,
– Your local bank will make you a mortgage loan for $80,000
at an interest rate of 8% per year,but you need to pay 20%
down,
– Your 45-year-old sister has a savings account with $20,000
in it for her retirement,earning 6% per year,
– If your sister is willing to lend you her retirement savings
for your down payment,how do you decide what a,fair”
rate of interest rate?
21
Finance School of Management
Providing Information
– A firm,earning $10 million in profits in a good year,is
faced with deciding whether to reinvest it in the business,
pay it out in cash dividends to shareholders,or use it to buy
back its own shares,
? Whenever a new financial instrument is introduced,
new possibilities for information extraction are
created as a ―by-product‖,
– The trading of option contracts & the information about the
volatilities of financial markets
22
Finance School of Management
Incentive Problems
? Incentive Problems may arise when one party to a
financial transaction has information that the other
party does not,or when one party is an agent that
makes decisions for another,
? Incentive Problems limit the ability of a financial
system to perform some of the functions,
23
Finance School of Management
The Moral-Hazard Problem
? The problem exists when having insurance against
some risk causes the insured party to take greater
risk or to take less care in preventing the event that
gives rise to the loss,
– Fire insurance for a warehouse
– Asymmetry information & financing business ventures
24
Finance School of Management
Quick Check
? Give an example of how the problem of moral
hazard might prevent you from getting
financing for something you want to do,Can
you think of a way of overcoming the problem?
25
Finance School of Management
The Adverse Selection Problem
? The problem exists when those who purchase
insurance against risk are more likely than the
general population to be at risk,
– Life annuities
– Car leasing
26
Finance School of Management
Quick Check
? Suppose a bank offered to make loans to
potential borrowers without checking their
credit history,What would the true of the types
of borrowers they would attract compared to
banks that did checks of credit history? Would
such a bank charge the same interest rate on
loans as banks that check credit history?
27
Finance School of Management
The Principal-Agent Problem
? The problem arises when those who bear the risks
associated with the decisions (the principals) delegate the
decision-making authority to others (the agents),
– Shareholders in a corporation delegate the running of the firm
to its managers
– Investors in a mutual fund delegate the authority to select the
mix of their security holdings to a portfolio manager
? Agents may not make the same decisions that the
principals would have made if they knew what the agents
know and were making the decisions themselves,
28
Finance School of Management
? A well-functioning financial system facilitates the
resolution of the incentive problems,
– Collateralization of loans
– Performance-based compensation of management
– Takeovers
– Conflicts of interest between shareholders and creditors,
“equity-kickers”
Dealing with Incentive Problems
29
Finance School of Management
Financial Innovation and the ―Invisible Hand‖
?Financial innovations are not planned by any
central authority but arise from the individual
actions of entrepreneurs and firms,
?Adam Smith’s observation,
In a competitive market economy,by
pursuing one’s own interest one frequently
promotes that of society more effectually
than when one really intends to promote it,
30
Finance School of Management
Financial Innovation and the ―Invisible Hand‖
? An Illustration,Credit Card Business
? Another Illustration,Mortgages & securitization
? Financial innovations have greatly improved the
opportunities for people to receive efficient risk-
return trade-offs in their personal investments and
more effective tailoring to their individual needs over
the entire life cycle,
? Analysis of consumer preferences and the forces of
competition among financial-service providers helps
one to make predictions about future changes in the
financial system,
31
Finance School of Management
Financial Markets
? Basic types of financial assets
– Debt (fixed-income instruments)
– Equity (the claim of the owners of a firm,residual claim,
limited liability)
– Derivatives (their value derived from the prices of other
assets,options and forward contracts)
? Classification by the maturity
– Money market (for short term debt,less than one year,
globally integrated and liquid)
– Capital market (long term debt and equity securities)
32
Finance School of Management
Fixed-income Claim Residual Claim
Markets Classified by Assets
33
Finance School of Management
Fixed-income Claim Residual Claim
Liability
Instrument
Preferred Stock Common Stock
Markets Classified by Assets
34
Finance School of Management
Fixed-income Claim Residual Claim
Liability
Instrument
Preferred Stock Common Stock
Fixed-income
Security Market Stock Market
Bond Market Common Stock Market
Markets Classified by Assets
35
Finance School of Management
Debt instrument Preferred Stock and Common Stock
Markets Classified by Maturity
36
Finance School of Management
Maturity
Less Than 1 Year
Debt instrument Preferred Stock and Common Stock
Maturity
More Than 1 Year
Markets Classified by Maturity
37
Finance School of Management
Markets Classified by Maturity
Money
Market
Capital
Market
Maturity
Less Than 1 Year
Debt instrument Preferred Stock and Common Stock
Maturity
More Than 1 Year
38
Finance School of Management
Derivatives Instruments Markets
Derivatives Instruments
Forward Contracts Market Options Market
39
Finance School of Management
Interest Rates
? Financial prices and financial market indicators
? An interest rate is a promised rate of return on a
fixed-income instrument and depends on the three
important factors,
– Unit of account
– Maturity
– Default risk
? A variety of interest rates
– commercial loan rate,mortgage rate
40
Finance School of Management
Effect of Unit of Account,An Illustration
15000 ￥
15260 ￥
15450 ￥
￡100
￡109
Time
3% ￥/￥ (direct)
1.73% ￥/￡/￡/￥
150 ￥/￡
9%￡/￡
140 ￥/￡
Japan U.K,
41
Finance School of Management
15000 ￥
16241 ￥
15450 ￥
￡100
￡109
Time
3% ￥/￥ (direct)
8.27% ￥/￡/￡/￥
150 ￥/￡
9%￡/￡
149 ￥/￡
Japan U.K,
Effect of Unit of Account,An Illustration
42
Finance School of Management
15000 ￥
(borrowed)
15450 ￥
15450 ￥
Repaid
￡100
Invested
￡109
Matures
Time
3% ￥/￥ (direct)
3% ￥/￡/￡/￥
150 ￥/￡
9%￡/￡
Forward ￥/￡
Japan U.K,
Effect of Unit of Account,An Illustration
43
Finance School of Management
Effect of Maturity
US Treasury Yield Curve,Jan 97
4.50
5.00
5.50
6.00
6.50
7.00
7.50
0 5 10 15 20 25 30
Years to Maturity
An
nu
ali
ze
d
Yie
ld
(%
)
44
Finance School of Management
Effect of Default Risk,Yield Comparisons
A p r i l ' 9 5 US C o r p o r a t e C o r p o r a t e
Tr e a s u r y H i g h Q u a l i t y M e d Q u a l i t y
1 - 1 0 Y e a r s 6, 9 2 % 7, 5 7 % 7, 8 6 %
1 0 + + Y e a r s 7, 6 5 % 8, 1 5 % 8, 5 5 %
45
Finance School of Management
Rates of Return on Risky Assets
%1010.0
1 0 0$
5$)1 0 0$1 0 5($
)(
??
??
?
??
?
R e t u r n
S t a r t P r i c e
ndC a s h D i v i d eS t a r t P r i c eE n d P r i c e
R e t u r n
Capital
gain or
loss
Dividend
payments
46
Finance School of Management
Market Indexes and Market Indexing
?Indexes is a measure of the overall level of
stock prices,
– Somebody might want a indicator or
benchmark against which to measure the value
or performance of their investment,
47
Finance School of Management
? Indexing is an investment approach
– that seeks to match the investment returns of a
specified stock-market index by holding all or a
representative sample in the case of very large index
(replicate),
– emphasizing broad diversification and low portfolio
trading activity (cost advantage and,passive”
investment strategy),
– It is impossible for all stock investors in the
aggregate to outperform the overall stock market,
Market Indexes and Market Indexing
48
Finance School of Management
S e c u r i t y R e t u r n s
- 6 0, 0 0
- 4 0, 0 0
- 2 0, 0 0
0, 0 0
2 0, 0 0
4 0, 0 0
6 0, 0 0
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Y e a r
%
R
e
t
u
r
n
B i l l s
B o n d s
S t o c k s
I n f l a t i o n
49
Finance School of Management
C o n s o l i d a t e d I n d i c i e s
1, 0 0 0 0
1 0, 0 0 0 0
1 0 0, 0 0 0 0
1 0 0 0, 0 0 0 0
1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995
Y e a r
I
n
d
e
x
(
L
o
g
S
c
a
l
e
)
B i l l s _ I n d e x
B o n d s _ I n d e x
S t o c k s _ I n d e x
I n f l a t i o n _ I n d e x
50
Finance School of Management
F r e q u e n c y o f R e t u r n s
0
10
20
30
40
50
60
70
- 5 0 - 4 0 - 3 0 - 2 0 - 1 0 0 10 20 30 40 50
P e r c e n t
P
r
o
b
a
b
i
l
i
t
y
F r e q _ B i l l s
F r e q _ B o n d s
F r e q _ S t o c k
F r e q _ I n f l a t i o n
51
Finance School of Management
Inflation and Real Interest Rates
? The nominal interest rate on a bond is the
promised amount of money you receive per unit
you lend,
? The real rate of return is defined as the nominal
interest rate you earn corrected for the change in
the purchasing power of money,
? National Consumer Price Index (CPI)—the unit of
account for computing the real rate of return
52
Finance School of Management
Nominal to Real
a t eI n f l a t i o n R
a t eI n f l a t i o n ReN o m i n a l R a t
R e a l R a t e
a t eI n f l a t i o n RR e a l R a t eeN o m i n a l R a t
?
?
?
?
????
1
)1(*)1()1(
53
Finance School of Management
The Value of an Investment of $1 in 1926
with Reinvestment,US Markets
Source,Ibbotson Associates
0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
Log
sc
ale
Year End
1
5520
1828
55.38
39.07
14.25
Nominal Dollars
54
Finance School of Management 0.1
10
1000
1925 1933 1941 1949 1957 1965 1973 1981 1989 1997
S&P
Small Cap
Corp Bonds
Long Bond
T Bill
Source,Ibbotson Associates
Log
Sc
ale
Year End
1
613
203
6.15
4.34
1.58
Real Dollars
The Value of an Investment of $1 in 1926
with Reinvestment,US Markets
55
Finance School of Management
Interest Rate Equalization
?Competition in financial markets ensures that
interest rates on equivalent assets are the
same,
?If the same terms (e.g.,maturity,default risk)
can be borrowed and lent on at different
interest rates,then interest-rate arbitrage can
be carried out,
56
Finance School of Management
Quick Check
? Suppose you have $10,000 in a bank account
earning an interest rate of 3%,At the same time
you have an unpaid balance on your credit card
of $5,000 on which you are paying an interest
rate of 17% per year,What is the arbitrage
opportunity you face?
57
Finance School of Management
The Fundamental Determinants of Rates of Return
? There are four main factors that determine rates of
return in a market economy,
– the expected productivity of capital goods
– the degree of uncertainty about the productivity of
capital goods
– time preference of people
– risk aversion
58
Finance School of Management
Finance Intermediaries
?Financial intermediaries are firms whose
primary business is to provide products that
cannot be obtained more efficiently by
transacting directly in securities markets,
59
Finance School of Management
? Clearing and settling payments,money-changers
? Taking deposits and make loans,commercial
banks
? All-purpose financial intermediaries,universal
banks
Banks
60
Finance School of Management
? Thrift institutions,savings banks,savings and
loan associations (S&Ls),credit unions
? In U.S.,thrifts
– Competing with commercial banks
– Specializing in marking home mortgage and
consumer loans
Other Depository Savings Institutions
61
Finance School of Management
? To allow households and businesses to shed specific
risks by buying insurance policies that pay cash
compensation if certain specified events occur,
– premiums
– Property and casualty insurance,covering accidents,
theft or fire
– Health and disability insurance,covering sickness or
inability to work
– Life insurance,covering death
Insurance Companies
62
Finance School of Management
? To replace a person’s pre-retirement earnings when
combined with Social Security retirement benefits
and private savings,
– Defined-contribution pension plan
– Defined-benefit pension plan
Pension and Retirement Funds
63
Finance School of Management
?A portfolio of stocks,bonds,or other assets
purchased in the name of a group of investors
and managed by a professional investment
company or other financial institution,
– Divisibility,record keeping,reinvestment of
receipts,efficient diversification
– Open-end mutual funds and NAV (net asset
value)
– Close-end mutual funds
Mutual Funds
64
Finance School of Management
? To help business,governments,and other entities
raise funds to finance their activities by issuing
securities,
? To facilitate and sometimes initiate mergers of firms
or acquisitions of one firm by another,
– Underwriting,committing to buy the securities at a
guaranteed future price
– Glass Steagall Act of 1933
Investment Banks
65
Finance School of Management
? To provide both financing and advices in running
the business of startup firms with inexperienced
managers,
–,go public” and exit
Venture Capital Firms
66
Finance School of Management
? Advising and administering mutual funds,pension
funds,and other asset pools for individuals,firms,
and governments,
Asset Management Firms
67
Finance School of Management
? Many financial service firms provide information as
a by-product of their main activities,but there are
firms that specialize in providing information,
– Rating agencies,Moody’s and Standard & Poor’s for
the securities business,Best’s for the insurance
industry
– Analysis of financial data,Bloomberg and Reuters
– Performance statistics on mutual funds,Lipper,
Morningstar,and SEI
Information Services
68
Finance School of Management
Financial Infrastructure and Regulation
? Financial infrastructure consists of
– legal and accounting procedures
– the organization of trading and clearing facilities
– the regulatory structure that govern the relations among the
users of the financial system
? Rules for trading
– To serve the function of standardizing procedures so that
the costs of transacting are kept to a minimum
? Accounting systems
– To present financial information in a standard format
69
Finance School of Management
Governmental & Quasi-Governmental
Organizations
? Central Banks
– To promote public policy objectives by influencing
certain market parameters such as the supply of the
local currency,
– The People’s Bank of China,Federal Reserve System,
the Bank of England….,
– At the heart of a country’s payments system,the supply
of local currency and the clearing system for the banks,
70
Finance School of Management
Governmental & Quasi-Governmental
Organizations
? Special-Purpose Intermediaries
– To encourage specific economic activities by making
financing more readily available or by guaranteeing
debt instruments of various sorts,
– To insure bank deposits,to promote economic stability
by preventing a breakdown in part or all of the financial
system,
71
Finance School of Management
Governmental & Quasi-Governmental Organizations
? Regional and World Organizations
– Bank for International Settlements (BIS) in Basle,Switzerland,to
promote uniformity of banking regulations
– International Monetary Fund (IMF)
? monitoring economic and financial conditions in member countries,
? providing technical assistance,
? establishing rules for international trade and finance,
? providing a forum for international consultation,and most
importantly,
? providing resources that permit lengthening the time necessary for
individual members to correct,imbalances” in their payments to
other countries
– World Bank,to finance investment projects in developing countries by
selling bonds in developed countries
