Financial Instruments and Technology PDF

FINANCIAL INSTRUMENTS AND TECHNOLOGY  2 Session 1 Overview of the Financial Markets  3 TITRE DU DOCUMENT Session Objectives At the end of the session, y...

FINANCIAL INSTRUMENTS AND TECHNOLOGY  2 Session 1 Overview of the Financial Markets  3 TITRE DU DOCUMENT Session Objectives At the end of the session, you should: Be familiarized with the terminology, characteristics and mechanisms of financial markets, and financial institutions  4 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  5 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  6 DISCOUNTING: PV vs FV Suppose your friend owed you €100. Would you prefer him to pay you back €100 today, or €100 in a year’s time? If he paid you back today, you could put the money in a savings account and earn some interest, say, 2%. After one year, you would have €100 × 1.02 = 102. You would (of course) prefer to receive €100 today, because the opportunity cost (2%) is positive. In this example: The Future Value (FV) of €100 is €102 The Present Value (PV) of €102 is €100.  7 DISCOUNTING: PV vs FV In this (very simple) example, the following formula applies: 𝐹𝑉 = 𝑃𝑉 × 1 + 𝑖 €102 = €100 × 1.02 where 𝑖 is the annual interest rate To calculate a present value from a future value: 𝐹𝑉 𝑃𝑉 = (1 + 𝑖) €102 €100 = (1.02)  8 DISCOUNTING: PV vs FV What if the money was to be paid back in 2 years’ time, and the same interest rate 𝑖 = 2% were valid for the two years? At the end of the first year, the balance would be: €100 × (1.02) = €102 You could invest €102 for the second year at the same rate. At the end of the second year, the balance would be €102 × 1.02 = €100 × 1.02 × 1.02 = €100 × 1.02 2 = €104.04  9 DISCOUNTING: PV vs FV In general, if a cash flow 𝐶𝐹 is due in n years and the rate of interest is 𝑖, we have: 𝐶𝐹 𝑃𝑉 = (1 + 𝑖)𝑛 This is the formula that would apply to a simple loan, i.e., a loan that is repaid in full, with interest, at maturity, with no intermediary payments.  10 DISCOUNTING: PV vs FV Example : simple loan What is the present value of $250 to be paid in two years if the interest rate is 15%? $250 $250 2 = = $189.04 (1 + 0.15) (1.3225)  11 DISCOUNTING: Yield to Maturity One of the most important ways to calculate interest rates is the yield to maturity (YTM). The yield to maturity is the constant interest rate that equates the present value of future cash flows to the value of the debt instrument today. It is thus the total return for the investor on a bond, if it is held until it matures. For a simple loan, the yield to maturity equals the loan interest rate In the previous example, if we knew the 𝑃𝑉 ($189.04) and the future value ($250), we could solve for the interest rate that makes the discounted value of the F𝑉 equal to the 𝑃𝑉 : $250 2 $250 $189.04 = 2 ⇒ (1 + 𝑖) = ⇒ 𝑖 = 15% (1 + 𝑖) $189.04  12 PV of more than 1 cash flow A perpetuity is a constant series of cash flows, C, that occur every unit period (for example year) and continue forever: € C C C C C C C C C C C C C C C......... 1 2 3 4 5 6 7 20 21 22 23 24 25 26 1000 Period Attention: first payment occurs in one period 𝑪 𝑷𝑽 = 𝒓  13 PV of more than 1 cash flow A growing perpetuity is a series of cash flows, Ct, which occur every unit period (say year) and continues forever, where: the cash flow equals, C, at the end of the first year, and it grows at a constant rate, g, every unit period (year) after. € C......... 1 2 3 4 5 6 7 20 21 22 23 24 25 26 1000 Attention: first payment occurs in one period Period 𝑪 𝑷𝑽 = 𝒓−𝒈  14 PV of more than 1 cash flow An annuity is a series of constant cash flows, C, that occur every period for a fixed number of unit periods (generally years). The maturity of an annuity is the period of the last cash flow (T in the pattern below). € C C C C C C C C C C... 1 2 3 4 5 6 7 T-2 T-1 T T+1 T+2 T+3 T+4 1000 Period Attention: first payment occurs in one period 𝑪 𝟏 𝑷𝑽 = 𝟏− 𝑻 𝒓 𝟏+𝒓  15 PV of more than 1 cash flow A growing annuity is series of cash flows, Ct, which occur every unit period for a fixed number of periods (generally years), and: the cash flow equals, C, at the end of the first period grows at a constant rate, g, every period after until the period T, when the last cash flow occurs; the annuity is then said to have a maturity of T periods. € C Attention: first payment occurs in one period... 1 2 3 4 5 6 7 T-2 T-1 T T+1 T+2 T+3 T+4 1000 Period 𝑪 𝟏+𝒈 𝑻 𝑷𝑽 = 𝟏− 𝑻 𝒓−𝒈 𝟏+𝒓  16 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  17 Finance TITRE DU DOCUMENT What is “Finance” about? The term “Finance” is used to cover a broad category of things related to money, investing, borrowing, lending, budgeting, saving, and forecasting. However, on a philosophical level, it is more general than that. Finance is a pillar of human society: It is about allocating limited resources in the world through space and time; It is about motivating people to do productive things in the world; It is about supporting enterprises that bring together many people and ensuring that they get a return for their (potentially) useful activities; It is about the management of risk or uncertainty, as everything in life is indeed uncertain.  18 TITRE DU DOCUMENT Financial Institutions What are Financial Institutions? A financial institution is an entity that deals with financial and monetary transactions such as deposits, loans, investments, and currency exchange. Examples: Commercial Banks (BNP Paribas, Société Générale, Bank of America,...) Investment Banks (J.P. Morgan, Goldman Sachs, Barclays,...) Insurance Companies (AXA, MACIF, Allianz Life,...) Brokerage Firms (Fidelity, Vanguard,...) Central Banks (ECB, Fed,...)  19 TITRE DU DOCUMENT Financial Technology What Is Financial Technology? Financial technology is the technology and innovation that aims to compete with traditional methods in the delivery of financial services. Some technologies used in the finance industry are: Artificial Intelligence (banking fraud detection, chatterbots in banking customer service, etc.) Big Data (market research, banking fraud detection, portfolio strategy, etc.) Software Robotics (automatization of repetitive tasks, processing of financial information such as accounts payable and receivable, etc.) New asset classes. For instance, the blockchain (cryptocurrencies)  20 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  21 TITRE Markets? What Are Financial DU DOCUMENT A financial market is any marketplace in which the trading (buying and selling) of financial instruments (securities) occurs. A security is an instrument that holds a monetary value and that can be traded between two or more parties. More precisely, a security is a negotiable (tradable) financial instrument that is a claim on the issuer’s future income or assets. The issuer could be a company, a Government, a Municipality, etc. In essence, a security is a “piece of paper” that entitles the owner to some cash flow or asset.  22 TITRE DU Why would anybody DOCUMENT want to trade a security? People trade/invest in the financial markets to solve a need. In that respect, financial goods are the response to a need/desire. e.g., Need = to save for my retirement, Product= a share of a pension fund. The need is not always profit!! Securities can be broadly categorized into four types: Equity Securities (common or preferred stocks or shares) Debt Securities (bonds, Treasury bills/notes, bank notes) Derivative Securities (forwards, futures, options, swaps) Currencies (US Dollar, Euro, etc.) Depending on the type of securities traded on a financial market, the market is called the equity market, debt market, derivatives market, or Foreign Exchange Market (Forex).  TITRE–DU 23 Bonds and stocks DOCUMENT quick summary Bond Stock Not a share of ownership Share of ownership Fixed maturity No maturity Contractual payment No contractual payments (amounts & dates) Return = dividend + increase Return = interest of price Highest seniority Lowest seniority Stocks are riskier than bonds ➔Stocks should provide a higher return  24 TITREMarkets Why Are Financial DU DOCUMENT Important? We live in a complex, interconnected world in which financial markets play a very important role: Financial markets channel funds from lenders to borrowers (or savers to investors) promoting economic efficiency; Financial market activities affect individuals (personal wealth), business firms and the entire economy; Well-functioning financial markets are key factors in producing high economic growth.  25 TITREMarkets Why Are Financial DU DOCUMENT Important? Financial markets perform the essential economic function of channelling excess funds from lender-savers to those who have a shortage of funds. Lender-Savers: Borrower-Spenders: Households Business firms Business firms Government Government Households Foreigners Foreigners A video on financial markets from Investopedia: https://www.investopedia.com/terms/f/financial-market.asp  26 TITRE Functioning of DU DOCUMENT Financial Markets There are two different ways of channeling funds from lender-savers to borrower-spenders: Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets (direct finance). Borrowers borrow indirectly from lenders via financial intermediaries such as banks. A financial intermediary does this by borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders (indirect finance).  27 TITRE Functioning of DU DOCUMENT Financial Markets  28 TITRE Functioning of DU DOCUMENT Financial Markets Examples: a) Suppose General Motors needs to borrow funds to pay for a new factory to manufacture electric cars. It may borrow the funds by either: Get a loan from a bank… but not always possible (heavy regulation, limits…) Selling investors a bond, a debt security that promises to make periodic payments for a specific period. Selling them stock, a security that entitles the owner to a share of the company’s profits and assets. b) A Government who faces a deficit can issue bonds – usually to reimburse previous debts or bonds. Financial markets are important because they allow funds to move from people who lack a productive use for their capital to those who have such opportunities.  29 TITRE Functioning of DU DOCUMENT Financial Markets If you save $1,000, but there are no financial markets, then you can earn no return on this - you might as well put the money under your mattress. However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she is willing to pay you some interest for the use of the funds. Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets also improve the well-being of consumers, allowing them to time their purchases better (for example by borrowing money to buy a house).  30 TITREintermediaries Why are financial DU DOCUMENT important? Financial intermediation is indeed the primary means of moving funds from lenders to borrowers in financial markets. Instead of savers lending/investing directly with borrowers, a financial intermediary (e.g., a bank) plays the role of the middleman: The intermediary obtains funds from savers; The intermediary then makes loans/investments with borrowers. This component of the financial market is a more important source of financing than securities markets (such as equity markets). Indeed, financing by means of financial intermediaries exceeds securities markets financing in most developed countries. Financial intermediation is needed as it deals with the problems of transactions costs and asymmetric information and facilitates risk-sharing.  31 TITREintermediaries Why are financial DU DOCUMENT important? In a world without financial intermediation, a household or company ready to lend money (i.e., a lender-saver) must find another household (or a firm) that wants to borrow money (i.e., a borrower-spender). Problems: It is costly (in money and time) to establish the connection between the lender-saver and the borrower-spender. These costs are called transaction costs. Even if the connection is made, there is information asymmetry between the two parties, i.e., the lender-saver does not have enough information about the borrower-spender.  32 TITREintermediaries Why are financial DU DOCUMENT important? Financial intermediaries reduce transactions costs by developing expertise and taking advantage of economies of scale. Financial intermediaries make profits by reducing transactions costs A financial intermediary's low transaction costs means that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions: Banks provide depositors with checking accounts that enable them to pay their bills easily; Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary.  33 TITREintermediaries Why are financial DU DOCUMENT important? Financial intermediaries also reduce the impact of asymmetric information. The problem of asymmetric information arises when one party lacks crucial information about another party in the transaction, affecting decision-making. We usually discuss this problem along two fronts: adverse selection and moral hazard.  34 TITREintermediaries Why are financial DU DOCUMENT important? Adverse Selection Occurs before the transaction is established. Potential borrowers that are most likely to produce a bad (adverse) outcome are the ones most likely to seek a loan Similar problems occur with insurance where unhealthy people want their known medical problems covered https://www.investopedia.com/video/play/adverse-selection/  35 TITREintermediaries Why are financial DU DOCUMENT important? Moral hazard Occurs after the transaction is established. It refers to a situation where the borrower has incentives to engage in undesirable (immoral) activities making it more likely that (s)he will not pay back what was previously borrowed. Again, within the insurance sector, people may engage in risky activities only after being insured. http://www.investopedia.com/video/play/moral-hazard/  36 TITREintermediaries Why are financial DU DOCUMENT important? In addition to reducing transaction costs and addressing the issue of asymmetric information, financial intermediaries can help reduce the exposure of investors to risk, through a process known as risk sharing. Financial intermediaries create and sell assets with lower risks to one party in order to buy assets with greater risk from another party. This process is referred to as asset transformation, because in a sense, risky assets are turned into safer assets for investors.  37 TITRE Exchanges vs. OTCDU DOCUMENT Security market is a component of the wider financial market where financial securities can be bought and sold between different parties, based on demand and supply. There are two major types of security market: Centralized exchanges Broker-dealer networks, also known as Over-the-Counter (OTC) https://www.investopedia.com/terms/o/otc.asp  38 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  39 TITRE Equity Securities DUEquity and DOCUMENT Markets Equity securities are shares of ownership in a company. These are a claim to a share in the net income and assets of a business. The returns associated with holding a stock (share) come in two forms: Any increase in the stock price makes the investment more valuable; Stockholders (may) receive dividends (i.e., their shares of the profit the company makes) depending on the company’s earnings and policy. Two main types of equity are common stocks and preferred stocks.  40 TITRE DU DOCUMENT Primary - Secondary New stocks are issued by the company (or an underwriting bank) and sold to the first group of buyers to raise funds, through a process called initial public offerings (IPO), in the primary market. Previously issued stocks are then traded by investors in the secondary market. The price of a stock in the secondary market is largely determined by the forces of supply and demand. This distinction between the primary and the secondary market is valid for all the securities. Securities that are sold for the first time denote primary market transactions while all subsequent transactions are conducted on the secondary market.  41 TITRE DU DOCUMENT Primary - Secondary The secondary market does not provide financing to issuing companies as such companies are not involved in the transaction. However, companies tend to monitor closely the secondary market for their stocks because: They can get an idea of the price at which they can issue new stocks if they have financing needs. CEOs are often judged on the price of their companies’ stocks Since many people invest in the equity market, fluctuations in the price of stocks on the secondary market can have large-scale impacts, and that is why equity (stock) markets receive a lot of coverage in media.  42 TITRE Debt Securities andDU DOCUMENT Debt Markets Debt securities are financial assets that are created when one party lends money to another. The borrower (seller of the debt security) is required to repay the principal borrowed in addition to the cost of borrowing (interest) over time. Debt markets are markets where debt securities are traded. Debt markets allow governments, corporations and individuals to borrow. Common types of (long-term) debt security are: Distinction according to the issuer: Government bonds Corporate bonds Municipal bonds Zero-coupon bonds  43 TITRE Comparison per DU DOCUMENT geographical area USA Bank debt 18% Stocks 38% Euro Zone Bonds Stocks 44% Bank debt 24% 51% Bonds 25% Source : BCE-Financial Integration in Europe  44 TITRE Comparison per DU DOCUMENT geographical area Why those differences? Historical reasons, culture, religion Protection of the investors Enterprise governance Disclosure of information  45 TITRE Derivatives and DU DOCUMENT Derivatives Market A derivative is a financial instrument (contract) whose value is derived from the value of one or several assets or securities, called the underlying asset(s). Derivatives are used either to hedge risks (i.e., to reduce or eliminate different types of risk such as interest rate risk, credit risk, etc.) or to speculate. The derivatives market dwarves other markets, with its notional value estimated to be over $1 quadrillion dollars. Some examples: Forward: Private agreements to buy/sell something at a future date, traded over the counter. The price at which this transaction will take place is decided in the present. Options: Contracts that provide their owners (holders) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. More about derivatives during session 5.  46 TITRE Currencies and DU DOCUMENT Foreign Exchange (Forex) Markets The foreign exchange (Forex) market is where international currencies are traded, and exchange rates are set. There is no central marketplace for foreign exchange. Currency trading is conducted electronically over the counter (OTC); all transactions occur via computer networks among traders around the world. Given the scope of worldwide trading activities, Forex markets tend to be the largest and most liquid asset markets in the world with a daily volume of $6.6 trillion as of 2019. Changes in exchange rates affect the prices of imported goods and domestic products that rely on imported parts and raw materials. For example, when the US Dollar (Euro) strengthens, foreign purchase of American (European) products decreases.  47 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  48 Money, Price,TITRE Value DU DOCUMENT Finance deals with money and monetary transactions, but what is exactly money? Money is a medium of exchange (numeraire) that acts as a measure of value or as a standard for currency exchange. The price of each good (other than numeraire) is expressed as the number of units of the numeraire, i.e., money in the current world. Price and value are two totally different concept: Price is what we pay for something, or what the market thinks something is worth Value is a more theoretical notion that refers to what we believe something is worth intrinsically.  49 Money, Price,TITRE Value DU DOCUMENT For money to be used as a medium of exchange, there needs to be high degree of confidence in the economic and financial system. Why? Because a banknote, as a piece of paper, has no intrinsic value. Everybody accepts this intrinsically unvaluable piece of paper only because everybody expects that everybody else accepts is and so forth. Money, in its current form, is not backed by any commodity such as gold or silver as it used to be in the past. All kinds of money that are made legal tender by a government decree are called fiat money. https://www.investopedia.com/video/play/fiat-money/  50 Money, Price,TITRE Value DU DOCUMENT The quantity of money in an economy is determined by the monetary policy administered by central banks. In the United States, the central bank is the Federal Reserve System (also called the “the Fed”). In the European Union, the European Central Bank (ECB) is the entity administers monetary policy of the euro area. A video about the ECB and the Eurosystem. https://www.youtube.com/watch?v=TAlcFwGIQBg&ab_channel=EuropeanCentralBank Central banks are the most important financial institutions in the financial system.  51 Outline TITRE DU DOCUMENT Key structure of the introductory lecture: Reminder: Financial mathematics Key market concepts: Finance, Financial institutions/technology/markets Financial markets and intermediaries Equity/Bond/Derivatives/Currency markets Key valuation concept: Money, price and value Financial system/infrastructure/stability  52 TITRE Financial System DU and DOCUMENT Financial Infrastructure The financial system is composed of many types of financial institutions: central banks, commercial banks, insurance companies, mutual funds, investment banks, etc. Financial institutions are what makes financial markets work within the financial system. Without them, financial markets cannot function. Occasionally, a major disruption in the financial markets will occur, and we have a financial crisis – such as the 2007- 2008 “Great Financial Crisis” or the global economic recession caused by the COVID-19 pandemic. Financial infrastructure permits: The transfer of payments as well as the trading; The clearing (check payment details between banks) and settlement (transfer of funds from the buyer to the seller) of securities. A video on infrastructure from the ECB: https://www.youtube.com/watch?v=hc9ntZmB0i8&ab_channel=EuropeanCentralBank  53 TITRE Financial System DU and DOCUMENT Financial Infrastructure There are some “ingredients” which are necessary for the financial system to function properly: Property rights should be correctly enforced; The institutional framework (markets, justice system, etc.) should be transparent; There should be confidence in the institutional framework by participants. Lack of trust is a major source of market disruption. To ensure transparency, trust, and proper enforcement of property rights, financial institutions are heavily regulated within the financial system.  54 France TITRE DU DOCUMENT The French financial system is regulated by the Autorité des Marchés Financiers (AMF), an independent public entity with a remit to: Safeguard investments in financial products; Ensure that investors receive material information; Maintain orderly financial markets. The AMF regulates participants and products on French financial markets. Regulation of the banking and insurance sectors is carried out by the Autorité de Contrôle Prudentiel et de Résolution (ACPR). It is responsible for investigating disciplinary proceedings and, where appropriate, imposing financial and / or disciplinary sanctions in case of irregularities: “police of the banks”.  55 TITRE DU DOCUMENT Financial System At the European level, the Single Supervisory Mechanism established by the ECB is responsible for banking supervision. The Single Supervisory Mechanism (SSM) is a new system of banking supervision for Europe. It comprises the ECB and the national supervisory authorities (ACPR in France) of the participating countries. Its main aims are to: Ensure the safety and soundness of the European banking system; Increase financial integration and stability; Ensure consistent supervision among across different countries. A video on the Single Supervisory Mechanism (SSM): https://www.youtube.com/watch?v=xC_2N0Y20qQ  56 TITRE DU DOCUMENT Financial Stability According to the ECB, financial stability can be defined as: “a condition in which the financial system – intermediaries, markets and market infrastructures – can withstand shocks without major disruption in financial intermediation and in the effective allocation of savings to productive investment.” The financial system is said to be stable if it displays the following three key characteristics: The financial system is able to efficiently and smoothly transfer resources from savers to investors; Financial risks are assessed and priced reasonably and accurately and professionally managed; The financial system is in such a condition that it can comfortably absorb financial and real economic surprises and shocks.  57 TITRE DU DOCUMENT Financial Stability If one or a combination of the characteristics mentioned above are not being maintained, it is likely that the financial system is moving in the direction of becoming less stable, and at some point, might exhibit instability (financial crisis). A financial crisis is an important disruption in financial markets that is characterized by sharp declines in asset prices and the failure of many financial institutions. Example: the 2007- 2008 “Great Financial Crisis” or the global economic recession caused by the COVID-19 pandemic.