FIM Theory Summary 2022-2023 PDF

FIM THEORY SUMMARY FINANCIAL INSTITUTIONS AND MARKETS THEORY NOTES YEAR: 2022-2023 ISCEB X STUDIST ISCEB X STUDIST 1  FIM THEORY SUMMARY...

FIM THEORY SUMMARY FINANCIAL INSTITUTIONS AND MARKETS THEORY NOTES YEAR: 2022-2023 ISCEB X STUDIST ISCEB X STUDIST 1  FIM THEORY SUMMARY Table of Contents - Chapter 1. Why study financial markets and insDtuDons…. 2 - Chapter 2. Overview of the financial markets…… 3 - Chapter 3. What do interest rates mean and what is their role in ValuaDon…… 8 - Chapter 4. Why do interest rates change….. 10 - Chapter 5. How do risk and term structure affect interest rates….. 14 - Chapter 6. Are financial markets efficient 19 - Chapter 7. Fundamentals of financial insDtuDons: Conflict of interest… 22 - Chapter 8. Why do Financial Crisis occur and why are they so damaging to the economy….. 27 - Chapter 9. Central Banks 31 - Chapter 10. Monetary Policies 33 - Chapter 11. The Stock Market… 34 - Chapter 12. Bonds… 37 ISCEB X STUDIST 2  FIM THEORY SUMMARY Chapter 1: Why study financial markets and insBtuBons? Financial markets: Financial markets refer to pla2orms where financial assets, such as stocks, bonds, and deriva;ves, are bought and sold. § Financial markets are crucial in our economy: 1. Channeling funds from savers to investors, promoting economic efficiency 2. Market activity affects: personal wealth, business firms, and economy Debt Markets: Segments of the financial market that allow governments, corporaDons, and individuals to borrow. Some borrowers issue a security, called a bond, offering interest and principal over Dme. Security: Financial instrument which is a claim on the issuer's future income or asset Bond: Debt security that promises to make payments periodically for a specified amount of Dme Interest: Cost of borrowing The Stock Market: The market where stocks are traded. Stocks: Shares that represent ownership in a company. IniDally sold on the primary market to raise money. Then traded amongst investors in the secondary market. The Foreign Exchange Market: The market where internaDonal currencies are traded, and exchange rates are set. SEO: Secondary Equity Offering ISCEB X STUDIST 3  FIM THEORY SUMMARY Chapter 2: Overview of the financial market What is the funcDon of financial markets? Financial Markets channel funds from person or businesses without investment opportuniDes, to others with investment opportuniDes. This process allows for producing an efficient allocaDon of capital. Financial markets also improve the well-being of consumers, allowing them to Dme their purchases beber. What are the segments of Financial Markets? 1) Direct Finance Borrowers borrow directly from lenders in the financial markets by selling financial instruments which are claims on borrower’s future income or assets. 2) Indirect Finance Borrowers borrow indirectly from lenders via financial intermediaries by issuing financial instruments which are claims on the borrower’s future income or assets. Financial intermediaries: InsDtuDons or enDDes that act as middlemen between savers and borrows in the financial system. Structure of Financial Markets? ISCEB X STUDIST 4  FIM THEORY SUMMARY Debt Market The debt market is divided in to two categories, -Short term (Maturity < 1 year) debt -Long-term debt Equity Market Equity of firms are sold on the equity markets, which pays investors dividends and represent ownership claim in a firm. Primary market New securiDes issues are sold to iniDal buyers. Typically involved an investment bank who underwrites the offerings. Secondary market SecuriDes that have previously been issued are bought and sold. (e.g., NYSE) It involves brokers and dealers. Brokers: Brokers help clients buy and sell securiDes while overseeing their accounts. Dealers: Dealers are individuals or firms that buy and sell securiDes for their own accounts and own good. The secondary market serves two important funcDons: Provides liquidity for firms. Establishes a price for the securiDes, which could be useful for company valuaDon. Furthermore, secondary markets can be categorizing as follows: 1. Exchanges: Dealers at central locaDon buy and sell. 2. Over-the-counter markets: Dealers at different locaDon buy and sell. 3. Money market: Short-term (Maturity < 1 year) plus forex. 4. Capital Market: Long- Term (Maturity > 1 year) plus equiDes. InternaDonalizaDon of Financial Markets? The InternaDonalizaDon of Financial Markets is crucial to avoid that one country dominates the world stage. InternaDonal Bond Market and Eurobonds 1. Foreign bonds: denominated in foreign currency and targeted at foreign market 2. Eurobonds: denominated in one currency but sold in a different market ISCEB X STUDIST 5  FIM THEORY SUMMARY 3. DomesDc bonds: denominated in local currency and targeted at the local market Eurocurrency Market: Foreign currency deposited outside of the home country. Note that such transacDons are not possible with every currency. World Stock Market Foreign Stock Market Indexes: - Bel20: 20 most important Belgian companies listed in Euronext Brussels - Dow Jones Industrial Average (DJIA): 30 largest US companies - S&P 500: 500 largest companies trading in the US - NASDAQ Composite: all stocks trading on Nasdaq stock market - FTSE100: 100 largest UK companies trading in London - DAX: 30 largest German companies trading in Frankfurt - CAC40: 40 largest French companies trading in Paris - Hang Send: largest companies trading in Hong Kong - Strait Times: 30 largest companies trading in Singapore The decline of US Capital Markets: The US has lost its dominance in many industries. This is due to: - New technologies - 9-11 making regulaDon Dghter - Big risk of lawsuit - High costs Financial IntermediaDon: It is a primary way of transferring funds from lenders to borrowers. The intermediary acts as a middleman and obtains funds from savers and makes loans/investments with borrowers. Banks are considered the most important financial intermediaries. Financial Intermediaries are needed to: 1. Reduce TransacBon costs: Financial intermediaries make profits by reducing transacDon costs. This can be done by developing an experDse and taking advantage of economies of scale. Low transacDon costs provide customers with liquidity services, that make it easier for them to conduct transacDons. è Banks create checking accounts that enable depositors to easily pay their bills è Depositors can earn an interest on these accounts 2. Risk sharing: ISCEB X STUDIST 6  FIM THEORY SUMMARY Low transacDon costs help reduce the risk exposure. Intermediaries create and sell assets with lower risk to one party in order to buy assets with greater risk from another party. We call this process asset transformaBon. Financial Intermediaries are also a mean to help customers diversify their assets holding. They are allowed to buy, pool and sell assets to a diversified pool of individuals due to lower transacDon costs. 3. Asymmetric informaBon: The laber occurs when one party lacks crucial informaDon about another, thereby interfering with the decision-making process. We differenDate between 3 types: A. Adverse selecBon Happens before the transacDon occurs. People most likely to produce an adverse outcome are the ones who are most likely to seek a loan. B. Moral Hazard Happens arer the transacDon occurs. Risk that the borrower has incenDves to engage in immoral acDviDes and won’t repay the loan. C. Conflict of Interest Economies of Scope: FIs lower producDon costs of informaDon by using the informaDon for a diverse range of services Economies of scope may lead to conflict of interest. This is the case when one area hides or conceals informaDon from another area. Conflicts of interests create inefficiencies. Types of Financial Intermediaries 1. Finance companies: raise funds by selling commercial paper and issue bonds and stocks to lend to consumers to buy durable goods/for small operaDons 2. Mutual Funds: raise funds by selling shares to single investors and use them to purchase large diversified porsolios of stocks and bonds 3. Money Market Mutual Funds: raise funds by selling checkable deposit-like shares and use them to purchase liquid and safe short-term money market instruments 4. Investment Banks: advise companies on securiDes, mergers and acquisiDons, act as dealers. Note that Investment banks can not offer savings accounts, nor provide loans. Regulatory Agencies Prevent things from going wrong. They: Increase InformaDon to investors Ensure soundness of the market ISCEB X STUDIST 7  FIM THEORY SUMMARY Some of the most important Agencies are: 1. SecuriBes and Exchange Commission (SEC): requires companies to disclose informaDon about sales, assets…, restricts insider trading InformaDon disclosure is a tool to increase efficiency and reduce asymmetric informaDon 2. Federal Deposit Insurance CorporaBon: provides insurance of up to 250.000$ for each depositor, imposes restricDons 3. Federal Reserve System: examines the books of commercial banks, sets reserve requirements Financial Panic: a situaDon where depositors start doubDng the overall health of financial intermediaries and thereby start pulling out their funds. It leads to large losses and causes damage to the economy. The government implemented different types of regulaDons to protect the public and the economy. 1. RestricDons on the entry: regulaDons on who is allowed to set up an intermediary. People must obtain a charter from the government, this only if they are upstanding ciDzen and have a large amount of iniDal funds. 2. Disclosure: principles on bookkeeping, period inspecDon, disclose info to the public 3. RestricDons on Assets and AcDviDes: restricDon from engaging in risky acDviDes f.eg. Banks can’t buy shares of other companies, except in case of mergers 4. Deposit Insurance: as a form of protecDon against the failure of a financial intermediary 5. Limits on CompeDDon 6. RestricDons on Interest Rates: insDtuted arer the Great Depression due to the belief that unrestricted interest rates encouraged banking failure RegulaDons intend to improve control over the money supply. Reserve requirements: make it obligatory for all depository insDtuDons to keep a fracDon of their deposits in an account with the Federal Reserve System ISCEB X STUDIST 8  FIM THEORY SUMMARY Chapter 3: What do Interest Rates mean and what is their role in ValuaBon? Interest rates are among the most closely watched variables in the economy. The most accurate measure of interest rates is a concept know as yield to maturity. Cash flows: streams of cash payments to the holder Debt instruments are evaluated against each other based on the amount and the Dming of each cash flow. Present value analysis: evaluaDon, where the amount and Dming of a cash flow leads to its yield to maturity. It is based on the principal that a dollar of cash flow paid to you one year from now is less valuable to you than a dolor paid to you today, due to the fact that you could invest and earn an interest on it, as long as the laber are posiDve. Loan Principal: amount of funds provided by the lender to the borrower Maturity Date: date of repayment of the loan Loan Term: from iniDaDon to maturity date Interest payment: cash amount that the borrower must pay the lender for the use of the loan principal Simple Interest Rate: interest payment divided by the loan principal; it is the percentage of the principal that must be paid as interest to the lender In Europe: expressed annually In the US: expressed semi-annually The Yield to maturity (YTM) is the interest rate that equates today’s value with the present value of all future payments. During the life of a bond it will be traded several Dmes. Key-insights Price-YTM 1. When a bond is at par, the yield equals the coupon rate 2. Price and yield are always negaDvely related: if the interest rate increases, the price decreases 3. The Yield is greater than the coupon rate when the bond price is below par value ISCEB X STUDIST 9  FIM THEORY SUMMARY Note that yields on some kind of bonds can be negaDve, meaning that investors are willing to pay more than what they would receive in the future. A more accurate measure for the cost of borrowing is indicated by the real interest rate. It reflects the actual cost of borrowing as it indicates the interest rate adjusted for expected changes in price level. When the laber are low there are greater incenDves to borrow and less to lend. It is calculated as: Interest rate (nominal rate) – InflaBon We make the disDncDon between: 1. Ex ante real rate of interest: adjusted to the expected level of inflaDon 2. Ex post real rate of interest: based on observed level of inflaDon RelaDonship between Rates and Returns: Key-Insights 1. If the return = the yield, the maturity = the holding period 2. If the maturity is longer than the holding period, the interest rates increase and the price decreases, meaning that the investor incurs a capital loss 3. The longer the maturity, the greater the price change associated with the interest rate change 4. The longer the maturity, the more the return changes with the change in interest rate 5. Bonds with a high iniDal rate can sDll have a negaBve return if the interest rate rises Prices and returns are more volaDle for long-term bonds, due to the higher interest-rate risk. Note that there is no interest-rate risk for any bond whose maturity equals the holding period. Reinvestment risk: a scenario occurring if you have a series of short bonds over a long holding period, because the interest rate at which you reinvest is uncertain. As an investor you gain from interest rates going up, and you lose from interest rates going down. ISCEB X STUDIST 10  FIM THEORY SUMMARY Chapter 4: Why do interest rates change Asset: a piece of property that is a store of value When considering how to deal with an asset, following factors must be taken into consideraDon: 1. Wealth: total resources owned by the individual: as wealth increases, demand increases 2. Expected return: return expected over the next period on one asset: as expected return increases, demand increases 3. Risk: degree of uncertainty associated with the return: if risk increases, demand falls Standard deviaDon: Differences to the average 4. Liquidity: ease and speed with which an asset an be turned into cash: as liquidity increases, demand increases Supply and demand for Bonds: è More people will offer bonds if expected return is lower è More investor will supply bonds if the expected return is lower We call the point where Supply and Demand curve intersect the equilibrium. In a healthy economy the equilibrium happens millions of Dmes a day. In this point: Bonds demanded = Bonds supplied ISCEB X STUDIST 11  FIM THEORY SUMMARY Supply is defined as companies and governments issuing bonds in order to borrow money. Market equilibrium: occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price. However, markets do not always reach an equilibrium. We can have 2 possible situaDons: 1. Excess supply: if amount that people are willing to sell is greater than what people are willing to buy at a given price -> supply > demand 2. Excess demand: if the amount that people are willing to buy is greater than what people are willing to sell at a given price ->supply < demand Changes in Equilibrium: Factors that shir the demand curve (shir to the right for increase, shir to the ler for decrease): 1. Wealth: demand rises in business cycle expansion, falls in recession 2. Expected returns: ->if interest rates are expected to rise in the future, the demand for long-term bonds decreases -> if interest rates are expected to fall in the future, the demand for long-term bonds increases 3. Risk: if risk increases, the demand for a bond falls Note however, that if the risk of an alternaDve asset increases, the demand increases 4. Liquidity: -> an increased liquidity of the bond market leads to an increased demand for bonds ->an increased liquidity of the stock market leads to an increased demand for stocks … Factors that shir the supply curve: 1. Expected profitability of investment opportuniDes: supply increases in a business cycle expansion, falls in recession as there are fewer expected business opportuniDes 2. Expected InflaDon: increase in expected inflaDon increases the supply of bonds 3. Government acDviDes: higher deficits increase the supply of bonds ISCEB X STUDIST 12  FIM THEORY SUMMARY Case studies: 1. The Fisher effect The Fisher effect explains that a high expected inflaBon rate leads to high interest rates and a price decrease. This is due to the fact, that a rise in expected inflaDon leads to a decrease in expected return of bonds relaDve to other assets, thereby leading to a decrease in demand for bonds. In addiDon the real cost of borrowing declines due to the rise of expected inflaDon, causing an increase in supply of bonds. Combined, the 2 lead to a fall in the equilibrium price of bonds. As price and interest rates are negaDvely related, the interest rate increases as a consequence of the price decrease. 2. Business Cycle Expansion: a situaDon in which the amount of goods and services for the country is increasing => naBonal income is increasing ISCEB X STUDIST 13  FIM THEORY SUMMARY As naDonal income increases, demand for bonds also increases due to the fact that companies need more money in order to keep up with the increasing demand for goods and services. In a Business cycle expansion interest rates rise as a consequence of the increase in demand, and the price falls. 3. Low Japanese Interest Rates: in 1998 Japanese Interest rates on Treasury bills turned negaDve: How? The country suffered from deflaBon, causing the demand of bonds to increase. In addiDon, real rates increased, which led to the real cost of borrowing being higher and the supply of bonds to fall. Arer a long period of wealth, the bubble burst. There was a recession leading to a decrease in interest rates. Both curves shired to the ler, whereas the net effect finally led to an increase in bond prices. Many firms hire economists or consultants to forecast interest rates. Methods used are: - Supply and demand for bonds: use Flow of Funds accounts and personal judgement - Econometric Models: use past financial relaDonships and assume that they will hold in the future Economists and consultants make forecasts over: 1. Make decisions about assets to hold: If interest rates are expected to decrease: buy long bonds If interest rates are expected to increase: buy short bonds 2. Make decisions about how to borrow: If interest rates are expected to decrease: borrow short If interest rates are expected to increase: borrow long PredicDons made by financial economists are also useful to help forecast the strength of the economy, profitability of investments, and expected inflaDon. ISCEB X STUDIST 14  FIM THEORY SUMMARY Chapter 5: How do risk and term structure affect interest rates Price differences on bonds are a consequence of the risk structure of the interest rates. Spread/Margin: difference between 2 bonds at a given point in Dme; measured in basis points Features of interest-rate behavior of bonds: 1. Rates on different bond categories change from one year to the next. 2. Spreads on different bond categories change from one year to the next. In general, three risk factors are taken into consideraDon: 1. Default risk: situaDon occurring when the issuer of the bond is unable/unwilling to make interest payments when promised In many cases, default is considered to be the step before bankruptcy. It oren leads to a cross-over effect meaning that it also affects all other bonds, checking accounts etc. US-Treasury Bonds are generally considered to have no default risk, and are therefore called “default-free bonds”. The reason behind it, is that the government can simply print new money, increase taxes etc. to pay off its obligaDons. History although has shown that these bonds are not truly default-free. The spread between interest rates on bonds with and without default risk is called risk premium. It is a measure indicaDng how much addiDonal interest people must earn in order to be willing to hold that risky bond. Note that a bond with default risk will always have a posiDve risk premium. Increase in Default risk on Corporate Bonds: 1. Increase in risk shirs demand curve for Corporate Bonds to the ler. 2. The demand curve for Treasury Bonds shirs to the right, due to an increase in demand, considering that the default risk on government bonds is low/zero. 3. As a consequence: ->the price of Treasury Bonds increases -> interest rates decrease ->the price of Corporate Bonds decreases -> interest rates increase The spread between the interest rates on corporate versus Treasury Bonds grows. ISCEB X STUDIST 15  FIM THEORY SUMMARY Investors aim at knowing as much as possible about the default probability of a bond. This can be done through credit-raDng agencies. The most important agencies in this field are: Moody’s, Fitch and S&P. CASE STUDY: The global Financial Crisis and the Baa-Treasury Spread The Financial crisis of 2007, which started with the collapse of the subprime mortgage market shows that credit-raDng agencies can be wrong. The laber gave very good raDngs to bonds of companies, which ended up not being able to repay their debts. QuesDons on the quality of Baa bonds started to arise, the demand fell, whereas the demand for Treasury securiDes increased. As a consequence the spread Baa-Treasury increased from 185 to 545 basis points. 2. Liquidity: a liquid asset is one that can be quickly, easily and cheaply converted into cash; the more liquid an asset, the higher the demand Example: Corporate bonds becoming less liquid 1. As liquidity for Corporate bonds decreases, the demand shirs to the ler. As a consequence price decreases and interest rates increase. 2. At the same Dme the Treasury Market becomes more liquid, and the demand shirs to the right. As a consequence the price increases and the interest rates decrease. 3. Again the spread Corporate-Treasury grows. NOTE: The risk premium reflects not only the default risk but also lower liquidity. That is why it is oren referred to as risk and liquidity premium. 3. Income tax consideraDons: NOTE: Municipal bonds have a lower rate than Treasuries, as municipaliDes can default. The possibility of Munis going into default is perfectly illustrated by the Orange County (California) example in the early 1990s. ISCEB X STUDIST 16  FIM THEORY SUMMARY In addiDon Munis are less liquid than Treasuries. However, municipal bonds are exempted from federal income taxes, a factor having the same effect on the demand for municipal bonds as an increase in their expected return. Treasury bonds on the other hand are exempted from state and local income taxes, whereas corporate bonds are fully taxable. The tax advantage of municipal bonds over Treasury Bonds is higher, the bigger the tax. 1. Tax-free status shirs demand for municipal bonds to the right. 2. At the same Dme the demand for Treasury bonds shirs to the ler. 3. Municipal bonds end up with a higher price and lower interest rate than on Treasury Bonds. CASE STUDY: Bush tax cut and Obama repeal on bond interest rates The 2001 tax cut under Bush reduced the advantage of municipal debt over T-securiDes. since interest rates on T-securiDes were taxed at a lower rate. The Bush tax cuts were finally repealed under President Obama. The advantage of municipal debt increased again, since T-securiDes were taxed at a higher rate. Besides the risk factor, another influence on interest rates is maturity. Yield curve: a curve represenDng rates at different maturiDes, used to analyze the behavior of interest rates Various theories have been developed in order to analyze the term structure of a bond. A good theory must explain why: 1. Interest rates for different maturiBes move together. 2. Yield curves tend to have a steep upward slope when short rates are low and a downward slope when short rates are high. 3. Yield curves are typically upward sloping. Theories: 1. ExpectaDons Theory: explains 1 and 2, but not 3 It is assumed that bonds of different maturiDes are perfect subsBtutes. The expected return on bonds of different maturiDes is therefore assumed to be equal. ISCEB X STUDIST 17  FIM THEORY SUMMARY If the theory is correct the expected wealth is the same at the start for two random chosen strategies. Of course in reality the rates may unexpectedly change and the wealth differ. General formula used: the interest rate on a long term-bond equals the average of short rates expected to occur over life of the long-term bond The theory illustrates, that if short rates are expected to rise in future, the average of future short rates is above today’s short rate, therefore the yield curve is upward sloping. On the other hand, if the rates are expected to fall the curve will be downward sloping, or flat if the rates are expected to stay the same. (explanaDon for fact 1) Furthermore, it shows that when the short rates are low they are expected to rise and the long rate will therefore be above today’s short rate: the curve will have a steep upward slope. On the other hand, when the short rates are high they are expected to fall in the future, and the long rate will be below the current short rate: the curve will have downward slope. (explanaDon for fact 2) 2. Market SegmentaDon Theory: explain 3, but not 1 and 2 It is assumed that bonds of different maturiDes are not subsBtutes at all. The markets are seen as segmented, and interest rates at each maturity are determined separately. The theory explains that people typically prefer short holding periods. The demand for short-term bonds is therefore higher, due to the higher prices and lower interest rates. (explanaDon for fact 3) It can not explain fact 1 and 2 as it assumes that various rates are determined independently. 3. Liquidity Premium Theory: combines features of both ExpectaDons and Market SegmentaDon theory It is assumed that bonds of different maturiDes are subsBtutes, but not perfect subsBtutes. The theory explains again that people prefer short-term rather than long-term bonds. This therefore implies that investors must be paid a posiDve liquidity premium, to hold long term bonds. The liquidity premium creates again an upward sloping yield curve (explanaDon for fact 3). It explains fact 1 and 2 with the same reasoning as the Pure ExpectaDons theory. ISCEB X STUDIST 18  FIM THEORY SUMMARY Market predicBons of future short rates: IniDal research did not find much useful informaDon in the yield curve for predicDng interest rates. Nowadays it is considered a useful tool to analyze short-and long-term rates, but does not provide much informaBon about medium-term rates. Besides providing informaDon about future interest rates, the yield curve should help forecast inflaDon and real output producDon: è Rising rates are associated with economic booms è Falling rates are associated with recessions Junk bonds: Bonds with a raDng below BBB; come with a high default risk rate. ISCEB X STUDIST 19  FIM THEORY SUMMARY Chapter 6: Are financial markets efficient ExpectaDons are crucial in our financial system. To beber understand expectaDons we analyze the efficient market hypothesis. It is a framework to understand what informaDon is useful and what is not. Rate of return: sum of capital gains plus any cash payments The EMH sees expectaBons as an opBmal forecast when using all available informaBon. It predicts that: R*=R^OF The hypothesis predicts that all available informaBon are reflected in today’s share price in and efficient market. Furthermore it assumes that the market is always right. The idea behind the EMH is that when an unexploited profit opportunity on a security arises, investors rush to buy unDl the price rises to the point that the returns are normal again. In an efficient market however, all unexploited profit opportuniBes will be eliminated. NOTE: It is crucial to acknowledge that not every investor needs to be aware of the situaDon. A few suffice to eliminate the unexploited profit opportuniDes. By doing so, they make a profit themselves. NOTE: The EMH holds even if there are uninformed, irraBonal parDcipants in the market. Favorable evidence for the EMH: 1. Investment analysts and mutual funds do not beat the market: approximately 90% of mutual funds underperform. BeaDng the market would only be possible through insider trading, which is illegal. Mini-Case: Raj Rajaratnam: investor who ended up in jail due to insider trading 2. Stock prices reflect publicly available informaDon: anDcipated announcements do not affect the price: previously announced informaDon does not bring about changes as it is already reflected in the price. 3. Stock prices and exchange rates close to random walk are unpredictable: if stock prices were fully predictable price changes would be near zero and this has never been the case. 4. Technical analysis does not outperform the market: although there are a few very good technical analysts, the EMH states that it is useless to set up rules trying to predict the behavior of stocks. ISCEB X STUDIST 20  FIM THEORY SUMMARY Unfavorable evidence for the EMH: 1. Small-firm effect: small firms tend to have higher share prices than bigger firms; this is considered an anomaly as it should be harder to find buyers and seller for small firms due to a higher risk exposure etc. 2. January effect: tendency of stock prices to have an abnormal posiDve return in January due to taxaDon; investors sell shares in December in order to take capital losses on tax return and reduce the tax liability and buy the stocks again when then new year starts Window-dressing: make your porsolio look beber than what it is 3. Market overreacDon: consequence of emoDonal invesDng; stock prices may overreact to news announcements 4. Excessive volaDlity: volaDlity = fluctuaDons in the stock prices 5. Mean reversion: stocks with low returns today tend to have higher returns in the future and vice versa 6. New info is not always immediately incorporated into stock prices ImplicaDons for invesDng: è Be aware of how valuable reports are è Be skepDcal of hot Dps è Remember that the market someDmes is slow to react, meaning that stock prices do not rise immediately è Do not overesDmate your own/someone else’s judgement: the EMH is only a prescripDon è Do not try to outguess the market by constantly buying and selling: especially as a small investor you incur very high commission costs. A possible strategy is the “buy and hold” strategy, meaning that it is advised to buy stocks and hold them for longer periods of Dme. In average this leads to the same returns, but to higher net profits, considering that the brokerage commissions are reduced. John Bogle is an investor who followed this strategy and became very successful. It is also advised, especially for small investors to buy into trackers or mutual funds. ISCEB X STUDIST 21  FIM THEORY SUMMARY Back to the EMH, it states that: 1. ExpectaBons are raBonal 2. Prices are always correct 3. Prices reflect the market Three implicaDons result from these statements: è One investment is as good as any other: stock picking is useless è Prices reflect all informaDon è The cost of capital can be determined from security prices Bubble: situaDon in which the price of an asset differs from its fundamental market value Behavioral finance: try to find a human behavior on financial markets ISCEB X STUDIST 22  FIM THEORY SUMMARY Chapter 7: Why do Financial InsBtuBons exist A vibrant economy requires a good financial system that moves funds from savers to borrowers. Facts of Financial Structure: 1. Stocks are not the most important source of external financing for businesses. 2. Issuing marketable debt and equity securiDes is not the primary way in which businesses finance their operaDons. 3. Indirect finance, which involves the acDviDes of financial intermediaries, is many Dmes more important than direct finance. 4. Financial intermediaries, are the most important source of external funds used to finance businesses. 5. The financial system is among the most heavily regulated sectors of economy. 6. Only large, well-established corporaDons have easy access to securiDes markets to finance their acDviDes. 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are typically extremely complicated legal documents. TransacBon costs: TransacDon costs can hinder the flow of funds to people with producDve investment opportuniDes. Financial intermediaries make profits by taking advantage of economies of scale and thereby reducing transacDon costs. Agency theory: Analysis of how asymmetric informaDon problems affect behavior. Lemons: bad used cars The Lemons Problem: How adverse selecBon influences financial structure 1. If we can’t disDnguish between good and bad securiDes, we are willing to pay only average of good and bad securiDes’ value 2. Result: Good securiDes are undervalued and firms won’t issue them, bad securiDes ISCEB X STUDIST 23  FIM THEORY SUMMARY are overvalued so too many issue leading to an inefficient market. Possible soluDons to problems of Adverse selecDon can be a private producBon and sale of informaBon or government intervenBon (annual audits f.eg). The Enron Case: Enron used to be a very successful firm engaged in energy trading. In 2001 however, the firm entered into severe financial difficulDes, but did not report the laber. Its auditor Arthur Andersen even plead guilty to obstrucDon of jusDce charges. The Enron Case was one of the biggest scandals of the past decades. Collateral: the most famous form of collateral is mortgage. It’s a scenario where the borrower gives an object as a kind of “security” to the lender, meaning that he does not own it directly anymore. In case the borrower is not able to repay the loan, the lender can sell the object. Moral hazard in equity contracts: The Principal-Agent problem The principal-agent problem is a conflict in prioriDes between a person or group and the representaDve authorized to act on their behalf. An example of the Principal-Agent problem is the conflict between Principal (owner/shareholder) and CEO. It can result in: 1. SeparaBon of ownership from control 2. Managers acBng in own interest The Principal-Agent problem can be solved by: 1. ProducBon on InformaBon 2. Government regulaBon to increase informaiton 3. Financial intermediaBon 4. Debt contracts Moral hazard in debt contracts: NOTE that debt will always be subject to moral hazard, as it creates the incenDve to take on very risky projects. ISCEB X STUDIST 24  FIM THEORY SUMMARY Moral hazard in debt contracts can be solved by: 1. Net worth and collateral 2. Monitoring, Enforcement of restricBve Covenants è Covenants are f.eg. Discourage undesirable behavior, encourage desirable behavior, keep collateral valuable, provide informaDon.. 3. Financial intermediaBon Financial repression: Financial repression includes government regulaBons, laws etc. that prevent financial intermediaries to work at full capacity. It is proven to lead to low growth. Reasons causing financial repression are: 1. Poor legal systems 2. Weak accounDng standards 3. Government directs credit 4. Finacial insDtuDons which have been naDonalized 5. Inadequate government regulaDon Note that financial repression can lead to a financial crisis. A financial crisis is a major disrupDon in financial markets. It results in the inability to channel funds from savers to producDve investment opportuniDes. China can be seen as a Counter-example for this. The country has a booming economy, whereas the financial developments are in its early stages. This is due to the fact, that people’s savings are very high. To conDnue its growth, China needs to start allocaDng capital more efficiently or it will end up in a crisis Mini-Case: Should we kill all the lawyers Legal work in financial relaDonships is mostly about contract enforcement. It is used to establish and maintain important property rights, without which investment opportuniDes would be limited. ISCEB X STUDIST 25  FIM THEORY SUMMARY Conflict of interest: It is a type of moral hazard that occurs when a person or insDtuDon has mulDple interests, and serving one interest is detrimental to the other. In financial insDtuDons we generally consider 3 types of conflicts: 1. UnderwriBng and reserach in Investment Banking: Investment Banks can research companies and underwrite securiDes for sale. Research should be unbiased and accurate. Considering that Underwriters have it easier if research is posiDve, if a company acts as both it may lead to a conflict of interest between the interests of the firm and the public. It may lead to spinning: underpriced equity is allocated to execuDves who will promise future business to the investment bank 2. AudiBng and ConsulBng in AccounBng firms: Auditors: check the books of a firm and assess their quality and accuracy: the goal is an unbiased opinion of the firm’s financial health Consultants: for a fee, help firms with managerial, strategic and operaDonal decisions Again, if a firm acts as both, the opinions are clearly not objecDve, especially when the consulDng fees are high and it leads to a conflict of interest. 3. Credit assessment and ConsulBng in RaBng Agencies: RaDng agencies: assign credit raDng to a security issuance of a firm. The raDngs are used to assess the riskiness of a security. Consultants: for a fee, help firms with managerial, strategic and operaDonal decisions Again, if a firm acts as both it leads to a conflict of interest, especially if the consulDng fees are high. Remedies against Conflict of interest: 1. Sarbanes-Oxley Act of 2002 è Establishment of oversight board supervising accounDng frims è Increased SEC’s budget è Limited consulDng relaDonships auditors-firms è Enhanced criminal charges for obstrucDon è Higher quality of financial statements and boards ISCEB X STUDIST 26  FIM THEORY SUMMARY 2. Global Legal Seblement of 2002 è Severe link between research and underwriDng in Investment banks è Spinning is banned è AddiDonal requirements on independence of research reports ISCEB X STUDIST 27  FIM THEORY SUMMARY Chapter 8: Financial Crisis Financial crises are major disrupBons in financial markets characterized by a sharp decline in asset prices and firm failures. The basis for understanding of a financial crisis is the study of moral hazard and adverse selecDon. Although there are many regulaDons trying to eliminate both, they are sDll present. Sequence of events in a financial crises: 1. IniBaBon of Financial Crisis: DeterioraDon in Financial InsDtuDons’ Balance Sheets, Asset-Price decline, Increase in uncertainty 2. Banking Crisis: Economic acDvity declines, Banking Crisis, Adverse SelecDon and Moral Hazard problems worsen and lending contracts, economic acDvity declines 3. Debt DeflaBon: unanDcipated decline in price level, adverse selecDon and moral hazard problems worsen and lending contracts, economic acDvity declines A financial crisis can begin in several ways: è Credit boom and bust: due to mismanagement of financial liberalizaDon or innovaDon. The government safety nets weaken incenDves for risk managment, depositor ignor risk-taking and eventually losses accrue. Deleveraging starts. è Asset-price boom and bust: a pricing bubble starts, where asset values exceed their fundamental value. When the bubble bursts and prices fall, net worth falls as well. Moral hazard increases, deleveraging starts. è Increase in uncertainty: caused by f.eg. a stock market crash, the failure of a major financial insDtuDon Deleveraging: financial insDtuDons cut back in lending As a consequence of deleveraging, no one is lem to evaluate firms. The financial system loses its primary insDtuDons to address adverse selecDon and moral hazard. Furthermore loans become scarce. Financial insDtuDons start deterioraDng balance sheets and are caused into insolvency. If severe enough, this can lead to a bank panic and bank run. The insDtuDons must sell assets quickly, as cash balances fall, further deterioraDng their balance sheets. This can lead to a sharp decline in prices and debt deflaBon. ISCEB X STUDIST 28  FIM THEORY SUMMARY Debt deflaDon: asset prices fall, but debt levels do not adjust, thereby increasing debt burdens CASES: 1. The Great Depression StarDng from 1928/29 stock prices doubled in the US unDl the stock market collapsed by the end of 1929. A normal recession turned into a disaster, when severe droughts in the Midwest led to a sharp decline in agricultural producDon. In the following years many banks went out of business. Firms with prodcDve uses were unable to get financing, credit spreads and unemployment increased. Bank panics in the US spread to the rest of the world, decreasing the demand for foreign goods. Results were a rising discontent which led to the rise of fascism and WWII. 2. The Global Financial Crisis of 2007-2009 Financial innovaBon in mortgage markets: ->less-than-credit worthy borrowers found the ability to purchase homes through subprime lending Subprime lending: mortgage likely to get into into trouble Agency problems in mortgage markets: ->banks didn’t care if customers got into trouble: Mortgage originators did not hold the actual mortgage, but sold the note in the secondary market. The role of asymmetric informaBon in the credit raBng process: ->agencies didn’t wanna lose clients ->debt design was not addressable for raDng system, which resulted in meaningless raDngs which investors relied on CDO: Collateralized Debt ObligaBons: bad lending taken out of BS of the bank and sold to an SPV In a CDO securiDes/tranches are created based on default prioriDes, whereas the highest rated tranches suffer defaults last. The tranches are divided into: 1. Super senior: highest ranked 2. Senior 3. Mezzanine 4. Equity Note that in real life it is oren difficult to determine what a cash flow is worth. ISCEB X STUDIST 29  FIM THEORY SUMMARY SPV (special purpose vehicle): created to buy assets, create securiDes from those assets and sell those to investors -> company with special purpose; a kind of financial intermediary between investors and financial intermediary. Many suffered during the financial crisis of 2007-2009. We specifically consider: 1. US residenBal housing: the underwriDng standard fell, people were buying houses they could not afford. The lending standards allowed for nearly 100% financing, so owners had lible to lose by defaulDng when the housing bubble burst. Note: some experts argue that the low interest rates from 2003 to 2006 further fueled the housing bubble 2. FIs balance sheet: banks and other FI saw the value of their assets fall and the deleveraging process began. Banks started selling their assets and restrict the credit. A further fall in the stock market and rise in credit spread weakened the BS, finally causing a contracDon. 3. Shadow banking system: Shadow bank: company with oren a hedge or money market fund that provides loans 4. Global financial markets 5. Failure of major financial firms Sep 2007: Northern Rock: a bank relying on other FIs for funding, which was therefore ler without funding Mar 2008: Bear Sterns: failed and was sold to JP Morgan Sep 2008: Freddie Mac and Fannie May: both were semi US-government organizaDons which were listed on the NYSE Sep 2008: Lehman Brothers: filed for bankrupcty. This event took all the confidence in the Markets away. Sep 2008: Merrill Lynch: sold to Bank of America Sep 2008: AIG: liquidity crisis The Financial Crisis of 2007 caused the worst economic contracDon since WW2. It peaked in 2008. Eventually in March 2009, a bull market started, having the credit spreads fall and stock prices rising again. ISCEB X STUDIST 30  FIM THEORY SUMMARY 3. The European Sovereign Debt Crisis: The Eurocrisis Up unDl 2007, all countries that had adopted the euro found their interest rates converging to very low levels. At the same Dme, many countries were hit very hard, due to: è Lower tax revenue from economic contracBon è High outlays for FI bailouts è Fear of default causing rates to surge Greece was the first domino to fall. It was heavily affected by fraud in previous governments. As soon as the real numbers were published, the interest rates and the debt started rising due to fear of default. The country needed to be saved by the IMF, the EU, and the ECB. Yet unemployment rates climbed and the country was ler with huge bailouts to deal with. Other countries, such as Ireland, Portugal, Spain, and Italy followed pu}ng doubts on the survival of the EURO project. ISCEB X STUDIST 31  FIM THEORY SUMMARY Chapter 9: Central Banks The acDons of a Central Bank affect: è Interest rates è The amount of credit è And the money supply All these acDons directly impact the financial markets, but also the aggregate output and inflaDon. Federal Reserve: Central Bank of the US Federal Open Market Commibee (FOMC): meets and takes decisions about Open Market operaDons, sets interest rates, Dghtens monetary policies or eases them Ease or Dghten? Depends on: è The Economy: period of growth or recession? è InflaBon: too high or too low Central banker: Hawk or dove: A (monetary) hawk: someone who advocates keeping inflaBon low as the top priority in monetary policy A (monetary) dove: someone who pays more apenBon to other aspects of the economy, such as low unemployment Central banks mainly deal with 3 research documents: 1. Green book: detailed naDonal forecast for the next 3 years 2. Blue book: projecDons of the monetary aggregates with three alternaDve scenarios for monetary policy decisions 3. Beige book: state of the economy in each of the Fed districts. It is distributed publicly. ISCEB X STUDIST 32  FIM THEORY SUMMARY Paul Volcker: important Fed chair, who was able to fight inflaDon of almost 15% Volcker rule: proposes to restrict speculaDon and prop posiDons in Central Banks. According to Volcker greed is oren a cause for bubble, which may lead to crisis. Prop posiDon: workers in bank who can invest the money of Central Banks on the financial markets Oren a quesDon on the independence of central banks arise. If a bank is independent or not depends on each country, although research has proven that independent central banks lead to lower inflaDon. The European Central Bank: è Based in Frankfurt, considering that Germany is one of the largest European economies. è It was set up arer the introducDon of the digital Euro in 1999 è It is independent ISCEB X STUDIST 33  FIM THEORY SUMMARY Chapter 10: Monetary Policy Goals of Central Banks: 1. Price stability 2. Currency stability 3. Interest rate stabilit 4. Output stability 5. Economic growth 6. Low unemployment 7. Stability of the financial markets 8. Confidence 9. Lender of last resort What does the balance sheet of Central banks look like? ASSETS: government securiDes, discount loans LIABILITIES: currency in circulaDon Repo: Repurchase agreement: A repurchase agreement is an open market operaDon. It includes Central Banks creaDng opportunites for banks to borrow money. By means of a Repo a commercial bank can borrow money from Central banks on a regular basis. QuanDtaDve easing: QuanDtaDve easing on the other hand is a nonconvenDonal monetary policy tool. Central Banks “create” money not by using Repos but buy buying a lot of government bonds from the financial markets. Central banks should also prevent all bubbles that can be foreseen. This can someDmes be costly, or ineffecDve. ISCEB X STUDIST 34  FIM THEORY SUMMARY Chapter 11: The Stock Market Stocks: 1. Represent ownership in a firm 2. Earn a return Note that a return on stocks is earned in two ways: - As the price of the stock rises over Dme - When dividendes are paid to the stockholder (not done by every company) Dividends: part of the profit of a company 3. Stockholders have claim on all assets 4. Holders of stocks have the right to vote for directors and on certain issues 5. Two types: - Common stock: with right to vote and to receive dividends - Preferred stock: no right to vote, but receive a fixed dividend How stocks are sold: Stocks are traded on organized exchanges. Such as: - New York Stock Exchange - Euronext - Nikkei - LSE - DAX The word organized is used to imply a specific trading locaDon. In recent Dmes computer systems (ECNs) have replaced this idea. Electonic communicaDon networks (ECNs): allow brokers and traders to deal without the need of a middleman, thereby providing transparency, cost reducBon, faster execuBon, and amer-hours trading. ISCEB X STUDIST 35  FIM THEORY SUMMARY LisDng requirements generally exclude small firms due to tough regulaBons and high costs. On the other hand, stocks can also be traded in Over-the-counter markets. The best example for such a market is NASDAQ. In such markets, dealers stand ready to make a market, meaning that mulDple dealers set bids and ask prices. Thinly-traded-securiDes, are generally traded on such plasorms. Exchange Traded Funds (ETF): Recent innovaDon to help keep transacBon costs down while offering diversificaBon. ETFs represent a basket of securiDes or an index, whereas the exact content of the basket is known. They are traded on a major exchange, with very low management fees. Stocks are valued by determining the cash flow and discounDng them to the present. 4 different methods can be used to facilitate the process: 1. One-period valuaBon model: expected dividend and price over the next year 2. Generalized dividend valuaBon model: most general model, but the infinite sum may not converge 3. Gordon growth model: similar to the One-period valuaDon model but we assume that the dividend grows at a constant rate, g 4. Price Earnings ValuaBon model: analysis of how much the market is willing to pay for 1 dollar of earnings from the firms All these models provide very useful informaDon, but they encounter problems: - With esDmaDng growth - With esDmaDng risk - With forecasDng dividends In general, prices are set in compeBBve markets. The price is set by the buyer who is willing to pay the most, as he is considered the one who can make the best use of an asset. Case: The 2007-2009 Financial Crisis and the stock market: The financial crisis of 2007-2009 was the start of one of the worst bear markets. It lowered the growth factor, g in the Gordon Growth model, thereby driving down stock prices. Furthermore, the high uncertainty further weakened the prices. ISCEB X STUDIST 36  FIM THEORY SUMMARY Case: 9/11 and Enron Again, both events had a negaDve impact on the stock prices. Stock market Indexes: The laber are oren used to monitor the behavior of a group of stocks. The most famous indexes include the Dow Jones Industrial average, the S&P 500 and the Nasdaq composite. Buying Foreign Stocks Buying foreign stocks is useful from a diversificaBon point of view. American depository receipts (ADR): ADRs allow foreign firms to trade on US exchanges, facilitaDng their purchases. US banks buy foreign shares and issue receipts against these in US markets. RegulaBon: The SEC (security and exchange commission) plays a primary role in regulaDng the financial markets. The primary mission is to protect investors and maintain the integrity of security markets. Divisions of the SEC: 1. Division of Corporate finance: responsible for collecDng, reviewing and making available all of the documents 2. Division of Market regulaBon: establishes and maintains rules for efficient markets 3. Division of investment management: oversees and regulates the investment management industry 4. Division of enforcement: invesDgates violaDons of the rules and regulaDons established by other divisions ISCEB X STUDIST 37  FIM THEORY SUMMARY Chapter 12: Bonds Capital Market: Maturity greater than one year, typically used for long-term financing or investments ParBcipants: Purchaser: You and Me Issuers: federal and local governmetns: debt issuer CorporaDons: equity and debt issuers Trading: 1. Primary market for iniDal sale 2. Secondary market: - Over-the-counter (bonds) - Organized exchanges (stocks) Types: Bonds are securiDes that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates. 1. Treasury Notes: the US Treasury issues notes and bonds to finance its operaDons - Treasury Bill: less than 1 year - Treasury Note: 1 to 10 years - Treasury Bond: 10 to 30 years Treasury Bonds have no default risk, since the Treasury can print money to payoff the debt. Furthermore, they have very low interest rates which are oren referred to as “risk-free rates”. Treasury InflaBon-Indexed SecuriBes: principal amount is Ded to the current rate of inflaDon to protect investor purchasing power Treasury STRIPS: coupon and principal payments are “stripped” from a T-bond and sold as individual zero-coupon bonds Agency debt: Bonds issued by government-sponsored enDDes, such as Ginny May or Fannie May. This enDDes suffered a hard draw-back durin the crisis of 2007-2009. ISCEB X STUDIST 38  FIM THEORY SUMMARY 2. Municipal Bonds: issued by local, county, and state governments and used to finance public interest projects Tax-free municipal interest rate = taxable interest rate * (1-Marginal tax rate) Two types: - General obligaDon bonds: f.eg. Build a bridge - Revenue bonds: linked to a specific project Municipal bonds are not default-free. 3. Corporate Bonds: typically with a face value of 1000 dollars, pay interest semi- annually in the US and annually in Europe Corporate bonds can not be redeemed anyDme the issuer wishes, unless a specific clause exists (call opDon). The degree of risk varies with each bond. As a consequence also the required interest rate varies. RestricDve Covenants: RestricDve covenants describe things that a company may or may not do. They are used to miDgate conflicts with shareholder interests and may limit dividends. Usually they include a cross-default clause. Conversion: The process of converDng bonds into shares. Note that not all debt can be converted into equity. Secured bonds: mortgage bonds, equipment trust cerDficates Some kind of guarantee is given to bondholders. Unsecured bonds: debentures, subordinated debentures, variable-rate bonds (no fixed interest rate) Junk bonds: debt that is rated below BBB, issued by companies likely to go bankrupt Financial guarantees for bonds: Some debt issuers purchase financial guarantees to lower the risk of their debt. The guarantee provides for Dmely payment of interest and principal and are oren backed up by large insurance companies. Credit Default Swap: insurance that you get your money back in case of default of the issuer ISCEB X STUDIST 39  FIM THEORY SUMMARY Bond Yield calculaDons: Cash flows are idenDfied and discounted to the present. Coupon interest rate: The stated annual interest rate on the bond; usually fixed for the life of a bond Current yield: The coupon interest payment divided by the current market price of the bond Face amount: The maturity value of the bond. Indenture: The contract that accompanies a bond and specifies the terms of the loan agreement Market rate: The interest rate currently in effect in the market for securiDes of like risk and maturity Maturity: The number of years or periods unDl the bond matures and the holder is paid for the face amount Par value: The same as face amount Yield to maturity: The yield an investor will earn if the bond is purchased at the current market price and held unDl maturity InvesBng: - Bonds are typically less risky than equity, even though they sDll include a price risk and interest rate risk ISCEB X STUDIST 40