Financial Markets (1) PDF

Financial Markets - Giorgini Measuring interest rates: Cash flows: Different debt instruments have different streams of cash payments to the holder, with different timing. Present Value: is the current value of a future sum of money or stream of cash flows. It is determined by discounting the future...

Financial Markets - Giorgini Measuring interest rates: Cash flows: Different debt instruments have different streams of cash payments to the holder, with different timing. Present Value: is the current value of a future sum of money or stream of cash flows. It is determined by discounting the future value by the estimated rate of return that the money could earn if invested. 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 𝑃𝑉: (1+𝑖)𝑛 Face Value: il valore che “sicuramente” riceverai allo scadere dell’investimento (BTP) Simple Loan: the principal amount (nominal value) is repaid at maturity with additional interests. Fixed-payment loan: the principal amount is repaid by monthly payments including part of principal and interest rates. Coupon bond: fixed interest payment until maturity date, when the “face value” is repaid in full. → Bond con cedole, oltre alle cedole che vengono emesse ogni tot, alla fine del tempo di investimento riacquisirò anche i soldi investiti inizialmente. Discount bond (zero-coupon bond, ZCB): bought below face value, with face value repaid in full at maturity without interim coupon payments. → Una obbligazione viene venduta a 800, nonostante il suo valore nominale sia 1000, se io la compro allo scadere del tempo riceverò 1000 euro, guadagnando così 200 euro. Yield to Maturity (YTM) is the total annual return an investor can expect if they hold a bond until it matures, considering both the interest payments (coupons) and any gain or loss if the bond was bought at a discount or premium. → E’ semplicemente il tasso di interesse che mi porterà al valore futuro del mio investimento (i). To decide which of those investments will provide us the best investment we need to calculate the Present value for each and then compare it. 𝐹𝑖𝑥𝑒𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝐹𝑖𝑥𝑒𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝐹𝑖𝑥𝑒𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝐹𝑖𝑥𝑒𝑑 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 Fixed-payment loan: 𝐿𝑉: 1+𝑖 + + +... + (1+𝑖)2 (1+𝑖)3 (1+𝑖)𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐶𝑜𝑢𝑝𝑜𝑛 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 Coupon Bond:𝑃 = (1+𝑖) + +... + + (1+𝑖)𝑛 (1+𝑖)2 (1+𝑖)𝑛 → When the coupon bond is priced at its face value, the YTM equals the coupon rate. The yield to maturity is greater than the coupon rate when the bond price is below its face value. Vice-versa, the yield to maturity is smaller than the coupon rate when the bond price is above its face value Inoltre se i tassi di interesse aumentano, le nuove obbligazioni sono più appetibili, quindi per compensare ciò, le obbligazioni già emesse con un tasso di interesse minore, diminuiscono il loro prezzo, permettendo così di “recuperare” un altro guadagno. → The price of a coupon bond and the yield to maturity are NEGATIVELY RELATED; as i (yield to maturity) increases, all denominators in the bond price formula must necessarily increase. 𝐹𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 Discount Bonds: 𝑖 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 Usually F-P should be positive, however in case of negative interest rates this isn’t possible. Real Cost of Borrowing: The real cost of borrowing is the actual cost of a loan after considering inflation. It reflects how much you are truly paying in terms of purchasing power. Even if you pay a nominal interest rate, inflation reduces the real value of your payments, making the effective cost lower. 𝑒 Fisher Equation: 𝑖𝑟 = 𝑖 − π → When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. → When the real interest rate is high, there are fewer incentives to borrow and greater incentives to lend. The good and the bad of inflation: Positive Negative Correlated with economic growth Decrease in purchasing power for consumers  Can allow for the adjustment of real wages if Discourages savings if inflation is too high coupled with growth and productivity and wages keep up with growth in prices Can promote spending and disincentivize money Often associated with rising inequality, as inflation saving can benefit the wealthy while harming low-income workers who face wage rigidities Debt is eased with inflation when revenues are When out of control, can lead to hoarding of insufficient to cover debts goods and shortages if consumers fear prices will continue to rise in the future Rate of return: is a way to measure how much money you make from an investment. It includes two main parts: - Current Yield: This is the money you get regularly from the investment, like interest from a bond or dividends from stocks. - Rate of Capital Gain: This is how much the value of your investment goes up (or down) over time 𝐶 𝑃𝑡−1 −𝑃𝑡 𝑅= 𝑃𝑡 + 𝑃𝑡 → C= coupon, Pt= purchase price, 𝑃𝑡−1 = Selling Price → The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period. Se io compro un bond con cedole e lo tengo fino alla scadenza, per forza il rendimento a scadenza sarà uguale al tasso di rendimento, se io invece vendo prima il bond, allora invece che 500$ magari ne prendo solo 200$. Volatility of bond returns: Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. There is no interest-rate risk for any bond whose time to maturity matches the holding period, since the price at the end of the holding period is already fixed at the face value. If an investor’s holding period is longer than the term to maturity of the bond, the investor is exposed to a type of interest-rate risk called reinvestment risk, because the money received at maturity from the short-term bond needs to be reinvested at a future interest rate that is uncertain. Macaulay: The fact that two bonds have the same maturity date doesn’t necessarily mean they have the same interest rate risk. This is because different bonds may have different cash flow structures. Macaulay recognized that a coupon bond can be thought of as a series of zero-coupon bonds representing each future payment. Macaulay defined duration as the average time it takes to receive all payments from a bond. In other words, duration is the weighted average of the times at which payments are made, with weights based on the proportion of each payment relative to the bond’s total value. 1. The longer the term to maturity of a bond, the greater its duration 2. When interest rates rise, the duration of a coupon bond falls 3. The higher the coupon rate on the bond, the lower the bond duration 4. The duration of a portfolio of securities is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each (additive) 𝐶𝑃𝑡 𝐶𝑃𝑡 ∆𝑖 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = Σ 𝑡 𝑡 /Σ 𝑡 %∆𝑃 ≈− 𝐷𝑈𝑅 1+𝑖 (1+𝑖) (1+𝑖) The greater the duration of a security, the greater its interest-rate risk. Determinants of asset demand: Asset: is something of value or a resource that is owned by an individual or an organization and is expected to provide future economic benefits. Four factors that influence the demand for assets: - Wealth, the total resources owned by the individual, including all assets. Positively related to the quantity demanded. - Expected return of one asset relative to alternative assets. Positively related to the quantity demanded.  - Liquidity, the ease and speed with which an asset can be turned into cash. The more liquid an asset is relative to alternative assets, the more desirable it is, and the greater will be the quantity demanded for it. - Risk, the degree of relative uncertainty associated with the return. If an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall. Negative related to quantity. Supply and demand in the bond market: Hypothesis: interest rates on different securities tend to move together. Supply and demand are always in terms of stocks (amounts at a given point in time) of assets, not in terms of flows (asset market approach). The first step is to use the analysis to obtain a demand curve, which shows the relationship between the quantity demanded and any price point. The second step is to use the same assumption in deriving a supply curve, which shows the relationship between the quantity supplied and any price. 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. In the bond market, this is achieved when the quantity of bonds demanded equals the quantity of bonds supplied. Movement along the curve: When the quantity demanded changes as a result of a change in the price of a bond. Shift in the demand curve: when the quantity demanded changes at each given price (or interest rate) of the bond, in response to a change in some factors besides the bond’s price or interest rate. - Growing wealth: the demand for bonds rises and the demand curve for bonds shifts to the right - Recession: the demand curve shifts to the left. Se diminuisce il guadagno non voglio investire Shift in the demand for bonds: Increase in Expected Inflation lowers the expected return on existing bonds, reducing demand and shifting the demand curve to the left. Increased Risk of bonds also decreases demand, shifting the curve left. Increased Liquidity of bonds raises demand, shifting the curve to the right. Shift in the supply for bonds: Economic Expansion and higher investment profitability lead to an increased supply of bonds, shifting the supply curve to the right (opposite in a recession). The real cost of borrowing is measured by the real interest rate, which is the nominal rate minus expected inflation. When expected inflation rises, the real cost of borrowing falls, increasing the supply of bonds and shifting the supply curve to the right. Higher government deficits also increase the supply of bonds, shifting the supply curve to the right. The fisher effect:When expected inflation rises, interest rates rise and bond prices fall Example: The low Japanese interest rates In the late 1990s and early 2000s, Japan's deflation led to increased bond demand and lower interest rates due to higher real returns on bonds and reduced bond supply. This situation, lasting nearly 25 years, shows how deflation affects bond markets and why financial managers use econometric models to forecast interest rates and guide investment decisions. Primary issuers of capital market securities are governments and corporations. Governments issue long-term notes and bonds for national debt and capital projects, while corporations issue bonds and stocks, deciding between debt and equity for financing—this is known as capital structure. - Primary Market: Where new bonds and stocks are issued. - Secondary Market: Where existing securities are traded, crucial for investors planning to sell bonds later. - Trading Venues: Include exchanges, which have strict rules for efficiency and integrity, and OTC (over-the-counter) markets, where most bond trading occurs. US Government Bonds: Treasury Bills: Maturity of less than 1 year. Treasury Notes: Maturity from 1 to 10 years Treasury Bonds: Maturity from 10 to 30 years. Treasury Inflation-Protected Securities (TIPS): Interest rate remains fixed, but principal adjusts with the Consumer Price Index (CPI). → Municipal Bonds: Include general bonds and revenue bonds. Agency Bonds: Issued by government-sponsored entities (e.g., Fannie Mae). Short-Term vs. Long-Term Rates: Short-term rates are more volatile and influenced by inflation, while long-term rates are less sensitive as they anticipate inflation returning to normal levels. Corporate Bonds:Issued by companies to borrow funds for long periods. Restrictive Covenants: Limit dividends, additional debt, and mergers to ensure cash is available for bond interest payments. These are outlined in the bond indenture. Call Provision: Allows the issuer to repurchase the bond if interest rates fall, often at a premium. This means if rates drop, the bond price rises, and the issuer might call the bond to reissue at lower rates. Convertible Bonds: Can be converted into a set number of shares of common stock. This feature allows bondholders to benefit from a rise in stock price. It’s a way for firms to avoid negative market signals. Green Bonds: A newer form of capital raising linked to Environmental, Social, and Governance (ESG) criteria, reflecting sustainability goals. Pricing coupon bonds: Discount: If the bond sells for less than its par value, it's selling at a discount. Premium: If the bond sells for more than its par value, it's selling at a premium. Financial guarantees for bonds: Financial Guarantees: Weaker issuers buy financial guarantees to lower bond risk, ensuring principal and interest payments are made even if the issuer defaults. Insurance Companies: Large insurers issue policies backing bonds, substituting their credit rating for that of the issuer. Credit Default Swap (CDS): Introduced by J.P. Morgan in 1995, a CDS provides insurance against default on bond payments. CDS acts as insurance against the risk of default, with protection buyers paying premiums for coverage and protection sellers agreeing to compensate for losses in case of default. CDS are typically available only to financial institutions, not retail investors. 2000 Commodity Futures Modernization Act: Removed regulatory oversight from derivatives, including CDS. This allowed investors to speculate on defaults without stringent regulation. 2008 Financial Crisis: Major CDS players included AIG, Lehman Brothers, and Bear Stearns. The total CDS market reached $62 trillion, exceeding the global GDP of approximately $50 trillion. The risk structure of interest rates: Risk structure: is the relationship among different interest rates of bonds having the same time to maturity. (different of risk between the treasury bonds and the bonds from another company) Risk of default: it occurs when the issuer of the bond is unable or unwilling to make interest payments when promised, or to pay off the face value when the bond matures. Spread: it refers to the difference between two interest rates, yields, or prices. It is commonly used to describe the difference between the yields of government bonds from different countries. (difference between a bond that has low risk and a treasury bond that has higher risk) The spread between the interest rates on bonds with default risk and "default-free" bonds, both of the same maturity, is called the risk premium. The risk premium indicates the additional interest (or return) that investors require to hold a risky bond over a risk-free bond. (The risk premium is the spread between low risk bonds and high) Flight to quality: in pratica se io ho un bond che ha più rischio ovviamente lo venderò e prenderò un bond che ha meno rischio, ad esempio prima avevo la apple e poi compro treasury bonds → questo è quindi il risk premium, se la apple è più rischiosa l’interesse dei suoi bond devono essere maggiori rispetto agli altri. When default risk increases for corporate bonds, several market dynamics occur: (ex: sri lanka) Corporate Bonds: Increased default risk decreases the demand for corporate bonds, leading to a drop in their prices and an increase in their interest rates. Treasury Bonds: Investors shift towards safer U.S. Treasury bonds, increasing their demand, which raises their prices and lowers their interest rates. Risk Premium: The overall effect is an increase in the risk premium, widening the spread between the interest rates of risky corporate bonds and default-free Treasury bonds. A bond with default risk will always have a positive risk premium because investors require extra return to compensate for the risk of default. If the default risk increases, the risk premium will also increase. Given the importance of default risk, investors need to know the likelihood of a corporation defaulting on its bonds. This information is provided by credit-rating agencies, which are investment advisory firms that rate the quality of corporate bonds based on their probability of default. Credit rating agencies: guardano i dati passati e provano a fare previsioni per creare dei rankings del market. → il rating per Moody per l’italia è Baa3 per S&P's BBB, la tabella è quindi divisa in un'area verde e una rossa che mostra il rischio in base all’investimento. Su bloomberg si può vedere una tabella che mostra per ogni nazione il rischio sia nel corto termine che nel lungo. Per trovare delle informazioni sui bonds guardare: worldgovernamnetbonds.com Fino all'anno scorso l'America non era mai stata downgraded in the market, adesso invece sono usciti degli articoli che dicono che le tasse non coprono i costi dello stato e quindi adesso c’è una probabilità di default. Stessa cosa è successa alla francia, ovvero che è scesa di un punto nel rating. The difference between interest rates on corporate bonds and Treasury bonds reflects not only the default risk of corporate bonds but also their liquidity. Corporate bonds are generally much less liquid than government bonds, making it more difficult and costly to sell them before maturity. Therefore, the risk premium is more accurately described as a "risk and liquidity premium." Se il bond è più liquido ovviamente la domanda per quel bond è maggiore, quando invece la liquidità è minore il tasso di interesse deve essere maggiore sennò nessuno lo prenderebbe. Term structure of interest rate: A plot of yields(rendimenti) on bonds with different maturities but the same risk and liquidity is called a yield curve, which describes the term structure of interest rates for specific types of bonds. 1. Interest rates on bonds of different maturities move together over time. 2. When short-term interest rates are low, yield curves are more likely to slope upwards; When short-term interest rates are high, yield curves are more likely to slope downwards or be inverted. 3. Yield curves almost always slope upwards → The term structure provides information for both the very short run and the long run but is less reliable for predicting movements in interest rates over the intermediate term. The nominal rate consists of a real interest rate and expected inflation, so the yield curve reflects both the future path of nominal interest rates and future inflation. A steep upward-sloping yield curve predicts a future increase in inflation. Yield curve: è una curva che mostra l’interesse in base al tempo, ad esempio se io compro un bond per 3 mesi avrò l’1% se invece lo compro per 20 anni allora vorrò 10% perchè è molto più rischioso. La curva può assumere diverse forme, addirittura potremmo ritrovare l’inversione dei tassi di interesse, in generale se i tassi di interesse sono alti nel medio termini nel lungo termine saranno più bassi otterremo quindi una inversione dei tassi di interessi e una curva che scende verso il basso, se invece gli interessi sono bassi nel breve termine molto probabilmente nel futuro saranno più alti→ upslope curve. C’è una relazione tra la fisher formula e la yield formula. La curva è invertita per l’america perché la cina ha venduto molti bond che aveva dell’america per quanto riguarda la situazione geopolitica e di conseguenza l’america si è ritrovata con molti bond vuoti in mano e la gente che non vedeva più bene l’america in quanto la cina è come se gli avesse tolto la fiducia e quindi l’america per farsi comprare i bond ha dovuto aumentare gli interessi. The expectation theory: It states that the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. The key assumption is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity - they are perfect substitutes. → if bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal. To see how the assumption of perfect substitutability leads to the expectations theory, consider: 1. Purchasing a one-year bond and, when it matures in one year, purchasing another one-year bond. 2. Purchasing a two-year bond and holding it until maturity 𝑒 𝑒 𝑒 𝑒 𝑖𝑡+ 𝑖𝑡+1 𝑖𝑛+ 𝑖𝑡+1+ 𝑖𝑡+2 +... + 𝑖𝑡+(𝑛−1) 𝑖2𝑡 = 2 →𝑖 = 𝑛 𝑛𝑡 The market segmentation theory: It views markets for bonds with different maturities as separate and segmented. Interest rates are set by supply and demand for each maturity, without influence from other maturities. Bonds of different maturities are not substitutes, and investors have strong preferences for specific maturities. If the bond’s maturity matches the holding period, the return is certain and risk-free. Market segmentation theory: è una teoria che spiega che ognuno di noi ha preferenze diverse, ad esempio alcuni di noi preferiscono short bonds e altri magari long one. The liquidity premium theory: It states that the interest rate on a long-term bond equals the average of expected short-term rates over its life plus a liquidity (or term) premium that reflects supply and demand conditions. Bonds of different maturities are substitutes but not perfect substitutes. Investors prefer shorter-term bonds due to lower interest rate risk, so a positive liquidity premium is required to encourage them to hold longer-term 𝑒 𝑒 𝑒 𝑖𝑛+ 𝑖𝑡+1+ 𝑖𝑡+2 +... + 𝑖𝑡+(𝑛−1) bonds. 𝑖𝑛𝑡 = 𝑛 + 𝑙𝑛𝑡 The bank balance sheet: Total asset = Total liabilities + capital A bank’s balance sheet is a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets). Banks obtain funds by borrowing and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans. Banks make profits by charging an interest rate on their asset holdings of securities and loans that is higher than the interest and other expenses on their liabilities Liabilities: Checkable Deposits: Bank accounts that allow writing checks. For the depositor, they are an asset because they are part of their wealth. For the bank, they are a liability because the bank must pay on demand. They are typically a low-cost source of bank funds. Non-transaction Deposits: The primary source of bank funds, including savings accounts and time deposits (certificates of deposit). Borrowings: Banks borrow from the Federal Reserve System, other banks, and corporations. Borrowings from the Fed are called discount loans. Banks also borrow reserves overnight in the Fed Funds market from other U.S. banks and financial institutions. Bank (Equity) Capital: The bank’s net worth, which is the difference between total assets and liabilities. It is raised by issuing new equity or from retained earnings. Bank capital serves as an "airbag" against a drop in asset value, which could lead to insolvency (liabilities exceeding assets, risking liquidation). Asset: Required Reserves: Funds banks must hold at the Federal Reserve to meet regulatory requirements. Excess Reserves: Additional funds held for liquidity and to cover withdrawals. Cash Items in Process of Collection: Checks written on accounts at one bank and deposited at another. They are considered an asset as they represent a claim on another bank. Deposits at Other Banks: Deposits held by smaller banks in larger banks. Used for services such as check collection, foreign exchange transactions, and assistance with securities purchases. Securities: Investments in stocks, bonds, and other financial instruments that generate income for the bank. Loans: Key source of profit for banks. They are an asset for banks (generating interest income) and a liability for borrowers. Other Assets: Physical capital owned by banks, such as buildings and equipment. Basic Banking: Asset Transformation: Banks make profits by selling liabilities with one set of characteristics (liquidity, risk, size, return) and using the proceeds to buy assets with different characteristics. This process is known as asset transformation. For example, a savings deposit can fund a mortgage loan. Io metto in banca 100 euro, la banca tiene sul mio conto il 10% quindi 10 euro e i restanti novanta li da a qualcuno che vuole un prestito e chiede a loro il 10% di interesse, alla fine la banca ha guadagnato sul prestito e può pagarmi l’1% sul mio conto. Borrow Short and Lend Long: Banks "borrow short and lend long," meaning they collect funds through short-term liabilities and extend loans with longer maturities. Deposits and Reserves: When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves. Bank Balance Sheet and Deposits: When a bank receives new deposits, it must keep a fraction of these as required reserves according to regulatory requirements (e.g., 10%). Use of Excess Reserves: Excess reserves—funds exceeding the required reserves—can be used by the bank to make loans or invest in securities. Profit from Loans: If the bank uses excess reserves to make loans, it earns income based on the interest rates charged on those loans. Costs of Deposits: Checkable deposits involve costs, such as paying interest to depositors and operational expenses. Profit Calculation: The bank’s profit from new deposits is calculated by subtracting the costs of managing the deposits from the income earned from using the excess reserves for loans or investments. Liquidity Management: Banks need to ensure they have enough readily available cash to handle deposit withdrawals. This involves acquiring sufficiently liquid assets to meet depositor demands. Asset Management: Banks aim to minimize risk by acquiring assets with low default probabilities and diversifying their asset holdings. Liability Management: Banks seek to acquire funds at the lowest possible cost. Capital Adequacy Management: Banks must determine and maintain an appropriate level of capital to ensure financial stability and meet regulatory requirements. Liquidity Management: A deposit outflow occurs when customers withdraw funds from their bank accounts, reducing the total amount of deposits held by the bank. This can impact the bank's liquidity and financial stability, as it needs to ensure it has sufficient liquid assets to meet withdrawal demands. Sta volta invece di mettere il minimo richiesto ovvero il 10% la banca decide di usare il 20% e di investire quindi questi soldi che sono i nostri, se io però adesso voglio ritirare tutti i miei soldi, la banca adesso come fa? la banca ha una riserva di soldi e quindi può ridarci i nostri soldi. How can a bank manage this situation? Borrowing from Other Banks:The bank can obtain reserves by borrowing from other banks in the interbank market. This involves paying interest on the borrowed funds. Selling Securities: The bank can sell some of its securities to generate cash. This provides immediate liquidity to cover the outflow but may incur transaction costs. Borrowing from the Federal Reserve: The bank can acquire reserves by borrowing from the Federal Reserve through discount loans, which involves paying the discount rate. Reducing Loans: The bank can reduce its outstanding loans and deposit the recovered amount to increase its reserves. This may negatively affect customer relationships and involve costs if loans are sold to other banks. Asset Management: Return on Loans and Securities: Banks aim to achieve the highest returns on loans and securities while managing risk. Risk Management: Banks seek borrowers with high interest rates and low default risk. They also purchase securities that offer high returns with minimal risk. Diversification: To reduce risk, banks diversify by holding various types of assets and approving a range of loans to multiple customers. Liquidity Management: Banks must manage their liquidity to meet reserve requirements without incurring excessive costs. This involves holding liquid assets, even if they offer lower returns compared to other assets. Liability Management: Integrated Management: Many banks now use an Asset and Liability Management (ALM) committee to oversee both sides of the balance sheet, reflecting the importance of managing liabilities alongside assets. Capital adequacy: Banks have to make decisions about the amount of capital they need to hold for 3 reasons: 1. Bank capital helps prevent bank failure 2. The amount of capital affects returns for the shareholders/owners (equity holders) of the bank 3. A minimum amount of bank capital (bank capital requirements) is required by regulatory authorities. Return on Assets (ROA): A basic measure of bank profitability, ROA represents the net profit after taxes per dollar of assets. It indicates how efficiently a bank is generating profit from its total assets. Quanti soldi ha la banca mettendo in gioco i loans, ovvero quanto è brava la banca a gestire la liquidità. Return on Equity (ROE): ROE is the measure that shareholders focus on, as it shows how much profit the bank is earning on their equity investment. It is calculated as the net profit after taxes per dollar of equity capital, reflecting the return on the shareholders' investment. 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑡𝑎𝑥𝑒𝑠 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝑅𝑂𝐴 = 𝑎𝑠𝑠𝑒𝑡 𝑅𝑂𝐸 = 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 There is a direct relationship between Return on Assets (ROA), which measures the bank's efficiency, and Return on Equity (ROE), which measures the profitability for the bank's owners. This relationship is determined by the Equity Multiplier (EM), which is the ratio of assets to equity capital. The formula ROE = ROA × EM shows that when a bank holds less capital for a given amount of assets, the ROE increases. Therefore, lower bank capital can lead to higher returns for the bank's owners. However, while lower capital increases ROE, it also increases risk. Bank capital is essential for reducing the likelihood of bankruptcy, but it is costly because higher capital reduces the ROE for a given ROA Strategies for managing bank capital: Per far aumentare ROE si deve aumentare EM e per farlo bisogna ridurre le equity capital, per farlo bisogna comprare di nuovo gli stock della stessa banca (buyback, ovvero ti riprendi gli stock in cambio dei soldi ai tizi che lo avevano) oppure puoi comprare più securities il che è molto rischioso oppure paga maggiori dividendi agli shareholders. To lower the amount of capital relative to assets and raise the equity multiplier, the manager can do any of three things: - Reduce the amount of bank capital by buying back some of the bank’s stock. - Reduce the bank’s capital by paying out higher dividends to its stockholders, thereby reducing the bank’s retained earnings. - Keep bank capital constant but increase the bank’s assets by acquiring new funds and then seeking out loan business or purchasing more securities with these new funds. To raise the amount of capital relative to assets, the manager has the following three choices:  - Raise capital for the bank by having it issue equity (common stock) - Raise capital by reducing the bank’s dividends to shareholders, thereby increasing retained earnings that it can put into its capital account - Keep the capital at the same level but reduce the bank’s assets by making fewer loans or by selling off securities and then using the proceeds to reduce its liabilities Principal agent problem: traders might act in their own interest rather than the bank's. To combat this, financial institutions must implement strong internal controls. This includes maintaining a strict separation between traders and those responsible for bookkeeping, known as "Chinese walls," to avoid conflicts of interest. Managers also need to set limits on the volume of trades and the institution’s risk exposure. Additionally, risk managers must continuously monitor risk assessment procedures, using the latest technology and adhering to regulations to minimize risks. Case Study: Silicon valley bank 2023 Silicon Valley Bank (SVB), a major bank for tech startups, collapsed in March 2023 after a sudden rush of withdrawals by depositors. The bank's failure, the second-largest in U.S. history, was triggered by a concentration of clients in the tech industry, who needed cash due to rising inflation and interest rates. SVB had invested much of its deposits in long-term, low-yield bonds, and when it had to sell these at a loss to meet withdrawal demands, it spiraled into insolvency. The situation led to a broader loss of confidence in the banking sector. Notably, 88% of SVB's deposits were above the $250,000 insured limit, leaving most depositors unprotected. Financial frictions and credit spreads: A well-functioning financial system is crucial for a strong economy because it directs funds to individuals and businesses with productive investment opportunities. If the financial system fails, capital may be misallocated or not flow at all, leading to inefficiency or economic crises. Asymmetric information: where one party in a transaction has more or better information than the other, creates barriers known as financial frictions. These frictions make it difficult for lenders to evaluate the creditworthiness of borrowers, leading to higher interest rates to mitigate the risk of default. This results in a credit spread, which is the difference between the interest rates on business loans and those on completely safe assets. Stage one: Initiation Financial innovation and liberalization can lead to a credit boom, where unchecked risk-taking behavior increases. As loan losses grow, the value of banks' assets declines compared to their liabilities, shrinking bank capital. This forces banks to limit lending, a process known as deleveraging. With reduced capital, banks become riskier, potentially triggering bank runs and leading to a credit freeze, where less funding is available for productive investments. Additionally, asset-price bubbles can form when investor psychology drives asset prices, like stocks and real estate, far above their fundamental economic values. When these bubbles burst, asset prices drop, further reducing companies' net worth. Stage two: banking crisis Deteriorating balance sheets can push financial institutions into insolvency, where their net worth becomes negative and they can no longer meet their obligations to depositors or creditors, leading to business failures. This situation can trigger a bank panic, where uncertainty spreads, causing a bank run. In response, banks may need to sell off assets quickly to raise funds, leading to fire sales that can drastically reduce asset prices and worsen insolvency. As banks fail and fewer remain operational, the information about the creditworthiness of borrowers diminishes, increasing the risk of adverse selection. It occurs nearly every 20 years. Stage three: debt deflation Debt deflation occurs when an unexpected drop in prices (deflation) worsens firms' financial health by increasing the real burden of their debt. - Increased Real Debt Burden: Deflation raises the real value of debt (liabilities) without increasing the real value of assets. This causes firms’ net worth (assets minus liabilities) to decline.  - Default Risk: As the real debt burden increases, firms may struggle to meet their debt obligations, leading to defaults and decreased aggregate demand, which further exacerbates deflation. - Rising Real Interest Rates: Even if nominal interest rates fall, real interest rates may rise due to falling price levels, as described by Fisher’s formula. RMBS (Residential Mortgage-Backed Securities) are financial products backed by home mortgages, sold to investors. The 2008 crisis was caused when risky subprime mortgages bundled into RMBS began to default, collapsing the housing market. The link to the 1929 crash is the role of speculative bubbles and excessive risk. In 1929, stock speculation led to a market collapse, while in 2008, housing speculation through RMBS caused a financial meltdown. Both crises highlight how unchecked speculation can trigger economic disasters. Great Depression: In 1928-1929, rising stock prices led the Fed to tighten monetary policy. A Midwest drought caused farmer defaults, triggering a banking panic in 1930. By March 1933, a bank holiday declared by President Roosevelt resulted in the failure of over 30% of banks. This intensified financial problems, causing a 90% drop in investment, peak credit spreads, and severe debt deflation, which contributed to high unemployment. The global financial crisis (2007-2009): Risk-Taking Behavior: Investors pursued high-risk loans to buy houses, expecting to profit from rising prices while being able to walk away if prices fell. Mortgage brokers, driven by incentives, often encouraged borrowers to take on unaffordable loans or falsified information to secure mortgages. Weak Oversight: Commercial and investment banks, earning large fees from underwriting mortgage-backed securities and complex financial products, had weak incentives to ensure the quality of these products. Additionally, insurance companies like AIG wrote extensive credit default swaps (CDSs) without adequate risk assessment. Inflated Ratings: Credit-rating agencies contributed to the problem by giving inflated ratings to these risky financial products, misleading investors about their true risk. Housing Bubble Burst: The subprime mortgage market, which had grown rapidly due to low interest rates and rising housing prices, collapsed when the housing bubble burst. This led to a dramatic decline in the value of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), severely impacting banks’ balance sheets. Crisis Escalation: As banks faced mounting losses and deteriorating balance sheets, they began deleveraging by selling off assets, leading to a credit freeze. The stock market dropped by 50%, and the housing market collapsed, extending the crisis globally and forcing governments to implement austerity measures. Key Events: - August 2007: BNP Paribas suspends redemptions on funds hit by significant losses. - September 2007: Northern Rock collapses. - March 2008: Bear Stearns is forced to sell itself to JPMorgan. - September 2008: Fannie Mae and Freddie Mac are placed under government control. - September 15, 2008: Lehman Brothers files for bankruptcy. - September 16, 2008: Merrill Lynch is sold to Bank of America, and AIG faces a severe liquidity crisis due to its exposure to CDSs. Case study: Fannie Mae and Freddie Mac In 1992, Fannie Mae and Freddie Mac were given the role of promoting affordable housing, leading them to invest heavily in subprime mortgages. By the time the subprime crisis hit, they had over $1 trillion in risky assets and a thin capital buffer. This resulted in government intervention, placing them into conservatorship under the Federal Housing Finance Agency. The case illustrates the conflict of interest inherent in government-sponsored enterprises, which struggled to balance profit motives with public service, ultimately failing both stakeholders and the public. Origins of the federal reserve system: Before the 20th century, there was strong resistance to a central bank in the U.S. due to fears of centralized power. The Federal Reserve was established in 1913 after the Panic of 1907, which revealed the need for a central authority to manage liquidity during crises. After the 2008 crisis, the Fed began paying interest on bank reserves to control inflation, which discouraged lending. This reflects a trend toward more government intervention in markets, raising concerns about the Fed’s long-term role and its departure from its original purpose. Structure of the federal reserve system: The Federal Reserve Banks consist of 12 regional institutions, with New York, Chicago, and San Francisco holding the majority of assets. The New York Fed is particularly influential, and its president is a key voting member of the FOMC. The Federal Open Market Committee (FOMC) is made up of 12 voting members: 7 from the Board of Governors, the President of the New York Fed, and 4 other regional Fed bank presidents. The Chair of the Board of Governors also chairs the FOMC. The FOMC directs open market operations, setting the federal funds rate, which influences interbank overnight loans. "Tightening" monetary policy raises this rate to curb inflation, while "easing" lowers it to boost the economy. The FOMC doesn’t trade securities directly but issues directives to the New York Fed's trading desk. It also sets reserve requirements and reviews the discount rate. The "Beige Book" reports on local economic conditions and is the only public document from the Fed, which is often referred to as the "Fed" in the media. La banca federale è un sistema di 3 istituzioni: board of governors → political entity, they are appointed by the president of the united states and confirmed by the senate; Twelve federal reserve banks; Federal Open market committee→ seven members of the boards and the president of the federal bank of NY. The board of governors in Washington is responsible for the reserve requirements, the twelve federal reserve banks are responsible for deciding the interest rate. The central bank is selling bonds: who is really doing it is the federal open market committee. The board of directors will stay in charge for 14 years. Easing: quando io ho 1000 euro di bond e 1000 in contanti, la banca mi propone di darmi più contanti e io gli vendo i miei bond e loro mi danno il cash, se adesso io voglio comprare nuovi bond i tassi di interesse sarebbero minori in quanto ci sono più contanti in giro. E’ quando la banca vuole cambiare la quantità di denaro durante la notte facendo questa cosa riescono ad alzare o abbassare i tassi di interesse, nel caso del easing le persone sono più rilassate a scambiare soldi ad un tasso minore, un tasso deciso dalla banca federale. Tightening: quando non ti servono i soldi e quindi compri più bond però adesso io ho più bond che soldi e quindi l'interesse è maggiore in quanto ci sono meno soldi in circolazione. In questo caso invece, come il giappone, noi abbiamo troppi soldi adesso e quindi da alle persone i bond così noi prendiamo le cedole, e adesso abbiamo meno soldi per imprestargli agli altri, perchè avendo meno soldi non possiamo più imprestargli agli altri e quindi i tassi saranno molto più alti. Beige book: è un libro dove tutte le 12 banche scrivono un rapporto sulla situazione macroeconomica. FED vs ECB: Central bank independence is twofold: - Instrument independence: the ability to set monetary policy instruments. - Goal independence: the ability to set the goals of monetary policy. Political pressure on the Fed could lead to an inflationary bias since politicians focus on short-term goals, like lowering interest rates before elections, which can cause long-term inflation. Putting the Fed under Treasury control is risky as it could be used to finance large budget deficits by buying Treasury bonds. The Fed has resisted political control attempts. While the Fed is highly independent, the Eurosystem, established by the Maastricht Treaty, is even more so. The ECB's primary goal is price stability, defined as an inflation rate slightly below 2%. The ECB is more goal-independent than the Fed because its charter can only be changed by revising the Maastricht Treaty, requiring unanimous agreement among all signatories. Unlike the Fed, the ECB does not supervise financial institutions, and its operations are conducted by consensus without formal voting to avoid national biases. Il 2% è importante perché così la banca è felice e noi possiamo crescere anche come economia, The federal reserve’s balance sheet: The Fed's monetary policy affects its balance sheet, which includes assets and liabilities. - The monetary base is the total of the Fed’s liabilities (currency and reserves) and the Treasury’s currency. - Reserves are deposits at the Fed plus physical currency held by banks. - Total reserves include required reserves (mandated by the Fed) and excess reserves (additional reserves banks choose to hold). - The required reserve ratio is the ratio of reserves to deposits. The Fed typically earns profits because its assets (like government securities) yield higher interest rates than its liabilities (currency and reserves). The Fed increases reserves by purchasing government securities or providing discount loans to banks. The discount rate is the interest rate on these loans. Se io vendo i bond avrò più cash o il contrario nel mio balance sheet, per me i bond sono degli asset e per la banca però sono delle liabilities perchè mi devono pagare le cedole. La Fed ha una grossa riserva e con quella fanno miliardi di soldi ogni anno. Open market operations: An open market purchase increases reserves and deposits, expanding the monetary base and money supply. Conversely, an open market sale contracts reserves and deposits, reducing the monetary base and money supply. A discount loan also expands reserves, increasing the monetary base and money supply. When a bank repays a discount loan, reserves decrease, contracting the monetary base and money supply. Changes in reserves affect the federal funds rate, the key interbank overnight interest rate. The Fed uses this rate to directly influence monetary policy. Le uniche banche che possono interagire con la Fed sono solo le grandi banche, JP Morgan ecc. Per le banche bisogna mettere negli asset -100$ securities che sono i bond che io ho appena venduto alla Fed e negli asset sotto reserves +100$ che sono i soldi che la Fed mi ha appena dato. La fed prova tramite delle operazioni notturne a modificare la federal funds rate e cambia così il livello di soldi in giro. Monetary policies: azioni che cambiano la liquidità in circolo. Demand and supply in the market for reserves: Demand for reserves: Since autumn 2008, the Fed has paid interest on excess reserves at a rate slightly below the federal funds rate. When the federal funds rate is above this rate, the opportunity cost of holding excess reserves decreases. If the federal funds rate falls below the interest rate on reserves, banks will prefer to keep excess reserves rather than lend them out. Supply of reserves: The supply of reserves consists of non-borrowed reserves (NBR), which come from the Fed's open market operations, and borrowed reserves (BR), which are borrowed from the Fed. The main cost of borrowing from the Fed is the discount rate (id). If the federal funds rate (iff) is below the discount rate (id), banks will borrow from other banks instead of the Fed, resulting in zero borrowed reserves. An open market purchase lowers the federal funds rate, while an open market sale raises it. Increasing reserve requirements raises the federal funds rate, and decreasing them lowers it. When the federal funds rate equals the interest rate on reserves, an increase in this rate raises the federal funds rate. The interest rate on reserves sets a floor for the federal funds rate. Conventional monetary policy tools include open market operations, discount lending, and reserve requirements. Open market operations are: - Dynamic: Intended to change reserve levels and the monetary base. - Defensive: Aimed at offsetting factors affecting reserves and the monetary base. The Fed conducts most open market operations with Treasury securities due to their liquidity and high trading volume. Temporary open market operations are the main way to affect reserves. In a repo, the Fed buys securities with an agreement to sell them back in a short period (1-15 days). A repo is a temporary purchase that will be reversed. In a reverse repo, the Fed sells securities to a bank with an agreement to repurchase them later, temporarily reducing reserve balances. In July and August 2021, the volume of reverse repos increased after the Fed raised the rate paid on these agreements to 0.05% to prevent the federal funds rate from falling too low. Il reverse repo succede quando io voglio aumentare il mio capitale e quindi compro dei bond, questa operazione è stata molto comune dopo il covid perchè c’erano tantissimi soldi in circolazione e quindi la banca voleva comprare più bond, la fed ha quindi distribuito più soldi perché si ricordava il casino che aveva fatto con lehman brothers, non distribuendo abbastanza denaro e quindi durante il covid è successo questo. Se io diminuisco l’interest rate e sono la Fed, è ovvio che in un periodo di crisi io banca preferisco mettere i soldi nella fed a 0,5 piuttosto che metterli in una compagnia che mi darebbe l’1%, questo ha comportato che la maggior parte delle liquidità venisse spostata nella fed, spostando così un nuovo equilibrio. Discount window: The discount window allows banks to borrow reserves from the Federal Reserve. There are three types of credit: 1. Primary Credit: Offered to healthy banks overnight at the discount rate, typically 1% above the federal funds rate. 2. Secondary Credit: For banks in financial trouble with severe liquidity issues, at 0.5% above the discount rate. 3. Seasonal Credit: For small banks in agricultural areas with seasonal deposit patterns. The Fed's original role was as a "lender of last resort," providing reserves quickly during banking crises. This helps prevent financial panics but can create moral hazard, where banks might take on excessive risk knowing they can rely on the Fed for support. Reserve Requirements and interests on reserves: Reserve requirements are rarely used as a monetary policy tool because increasing them can lead to immediate liquidity problems for banks with low excess reserves. After the global financial crisis, banks accumulated large excess reserves. To raise the federal funds rate in this environment, the Fed would need extensive open market operations to remove these excess reserves from the banking system. Non-conventional monetary policy tools: Negative economic shocks can lead to the zero-lower-bound problem, where the central bank cannot lower interest rates further. In such cases, conventional monetary policy tools become ineffective, and non-conventional tools are used. These tools include: - Liquidity Provision: Providing additional liquidity to the banking system to ensure banks have enough resources to lend and support the economy. - Asset Purchases: Buying government securities or other assets to increase the money supply and lower long-term interest rates. - Commitment to Future Monetary Policy Actions: Communicating future policy intentions to shape market and economic expectations, thereby stimulating the economy when rates are near zero. Liquidity provision: Discount Window Expansion: In August 2007, the Fed reduced the discount rate to 50bps above the federal funds rate, then to 25bps. Use was limited due to stigma. Term Auction Facility (TAF): Established to provide loans through competitive auctions, similar to ECB operations. New Lending Programs: Expanded liquidity by directly lending to investment banks, and supporting purchases of commercial paper, mortgage-backed, and asset-backed securities. Provided loans to J.P. Morgan for Bear Stearns acquisition and to AIG to prevent failure. Asset Purchases: - Quantitative Easing (QE): Refers to the Federal Reserve's asset purchase programs, which expand its balance sheet and the monetary base to stimulate the economy. - QE1 (November 2008): The Fed initiated QE1 by purchasing $1.25 trillion in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. This aimed to lower interest rates on residential mortgages to support the housing market. - QE2 (November 2010): QE2 involved the Fed buying $600 billion in long-term Treasury securities at a pace of about $75 billion per month. This program aimed to reduce long-term interest rates to encourage investment spending and boost the real economy. - QE3 (September 2012): QE3 combined elements from QE1 and QE2, with the Fed purchasing $40 billion in mortgage-backed securities and $45 billion in long-term Treasuries monthly. It was an open-ended program designed to provide ongoing support to the economy. Despite these significant increases in the money supply, QE programs did not lead to a substantial rise in lending. Banks chose to hold more excess reserves rather than increase their loan-making activities. Management expectation: The Fed uses commitments to future monetary policy to influence market expectations and economic behavior. December 16, 2008 Announcement: The Fed lowered the federal funds rate target to 0-0.25% and indicated that “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” Conditional vs. Unconditional Commitment: - Conditional Commitment: The Fed’s statement was conditional, meaning the promise to keep rates low was based on the continued weak state of the economy. - Unconditional Commitment: A stronger commitment would have stated the Fed would keep rates at zero for an extended period regardless of economic conditions, potentially having a greater impact on long-term interest rates. Advantages of Unconditional Commitment: It provides clearer guidance and is likely to have a stronger effect on long-term interest rates compared to a conditional commitment. Monetary Policy tools of the ECB: non studiare, solo leggere Target Financing Rate: The ECB signals its monetary policy stance by setting this target rate, which influences the overnight cash rate—the interest rate for short-term loans between banks, similar to the federal funds rate in the U.S. Main Refinancing Operations: These are the ECB's primary method for providing liquidity to banks. They work similarly to the Fed's repurchase agreements (repos), where banks borrow from the ECB with securities as collateral. Longer-Term Refinancing Operations: Although less prominent, these operations provide banks with liquidity over a longer period. They resemble the Fed’s outright purchases or sales of securities. Marginal Lending Facility: Banks can borrow overnight from national central banks within the Eurozone at the marginal lending rate, set by the ECB. This rate acts as a ceiling for the overnight market interest rate, akin to the Fed’s discount rate. Deposit Facility: The ECB offers a deposit facility where banks can place reserves and earn interest. This rate is lower than the target financing rate and sets a floor for the overnight market interest rate, similar to the Fed’s interest on excess reserves. Reserve Requirements: The ECB requires all deposit-taking institutions to maintain a minimum amount of reserves. This ensures that banks hold a certain level of deposits in reserve accounts, influencing overall liquidity in the banking system. Price Stability: In recent decades, policymakers worldwide have recognized the social and economic costs of inflation. As a result, maintaining a stable price level has become a primary objective of economic policy. Price stability, defined as low and stable inflation, is increasingly seen as the most critical goal of monetary policy. Nominal Anchor: A crucial aspect of effective monetary policy is the nominal anchor—a nominal variable, such as the inflation rate or money supply, that stabilizes the price level. This anchor helps achieve the overarching goal of price stability. Monetary Policy: Monetary policymakers often face the time-inconsistency problem, where there is a temptation to implement a more expansionary monetary policy than anticipated by firms and individuals. While such a policy can temporarily boost economic output or reduce unemployment in the short run, it can undermine long-term stability. Strategy for Central Banks: To achieve better inflation performance over time, a central bank should avoid surprising the public with unexpectedly expansionary policies. Instead, it should focus on controlling inflation. Additionally, maintaining interest-rate stability is essential, as fluctuations in interest rates can create economic uncertainty and complicate future planning. Hierarchical vs. Dual Mandates: Hierarchical Mandates: Under the Maastricht Treaty, the ECB’s primary goal is to maintain price stability. Only after achieving price stability does the ECB aim to support broader economic goals like high employment and sustainable growth. This approach prioritizes price stability above other objectives. Dual Mandates: The Federal Reserve operates under a dual mandate, which means it has two co-equal goals: maintaining price stability and maximizing employment. The Fed’s mission involves promoting long-term economic growth and moderate long-term interest rates while balancing these two objectives. Inflation Targeting: Public Announcement: Setting medium-term numerical targets for inflation that are communicated to the public. Institutional Commitment: Ensuring that price stability is the primary long-term goal, with a firm commitment to achieving the inflation target. Information-Inclusive Approach: Using a broad range of economic variables to guide monetary policy decisions. Transparency: Clearly communicating the central bank's plans and objectives to the public and financial markets. Accountability: Holding the central bank responsible for meeting its inflation targets. ECB's Approach: The ECB aims for inflation to be "below, but close to 2% in the medium term," reflecting its commitment to inflation targeting. - Advantages: Reduces Political Pressure: Helps prevent political interference in monetary policy, which might otherwise lead to inflationary policies. Minimizes Time-Inconsistency: Reduces the risk of policy makers changing their approach in response to short-term pressures. - Criticisms: Rigidity: Some argue that inflation targeting imposes a strict rule that may limit the central bank's flexibility to adapt to unexpected economic conditions. Lessons from the Global Financial Crisis: Credit-Driven Bubbles: - Occur when easy credit inflated asset prices, creating a feedback loop: rising asset prices boost collateral values, encouraging more lending and further price increases. - These bubbles are dangerous as seen in the 2008 financial crisis. Irrational Exuberance Bubbles: - Driven by overly optimistic expectations rather than easy credit. - Less risky to the financial system; for example, the technology stock bubble of the late 1990s. Challenges in Addressing Asset-Price Bubbles: Difficulty in Identification:Spotting bubbles is hard; rising interest rates might not be effective as they may not deter investment in bubble-driven assets. Interest Rate Trade-offs: Raising rates significantly can slow the economy, increase unemployment, and reduce inflation below desired levels. Policy Recommendations: Focus on Limiting Risk-Taking: - Design policies to curb excessive risk-taking rather than directly targeting asset prices. - Macro-Prudential Regulation: Focuses on managing credit market risks through measures like countercyclical capital requirements. - Countercyclical Capital Requirements: Increase during booms and decrease during busts to reduce feedback loops and mitigate credit-driven bubbles. M2 as an Inflation Indicator: Definition: Includes M1 (currency, checkable deposits, travelers' checks) plus savings deposits, small time deposits, and retail money market mutual funds. M2 offers a broader view of the money supply and inflation trends compared to M1. M2 changes can signal potential inflation shifts, but there is typically a 12 to 18-month lag between changes in M2 and inflation response. Changing Role of the Federal Reserve System: Post-2008 Adjustments: Fed began paying interest on reserves to prevent inflation from increased money supply, disincentivizing excess lending. New Powers: The Fed can now provide emergency lending up to $4.5 trillion to various sectors, influencing private credit markets and consumer behavior. This involvement distorts market price discovery and can hide systemic risks. Implications: - Increased government intervention in markets, potentially setting a long-term path that diverges from the Fed’s original goals. - Concerns about long-term implications of these interventions on market functioning and systemic risk. The stock market: A share of stock represents ownership in a company. Investors can earn returns from stocks in two primary ways: - Capital Gains: The price of the stock may rise over time. If the stock's value increases, investors can sell their shares for a profit. - Dividends: Companies may distribute a portion of their earnings to shareholders in the form of dividends. These are periodic payments made to investors in addition to any potential capital gains. Risks of Stock Ownership: Stocks are generally riskier than bonds for several reasons: Lower Priority in Bankruptcy: Stockholders are paid only after bondholders and other creditors if the company faces financial trouble or bankruptcy. Uncertain Dividends: Unlike bond interest payments, dividends are not guaranteed and can fluctuate or be suspended based on the company's financial health. Unpredictable Price Increases: There is no assurance that the price of stocks will rise, and stock prices can be volatile. Types of Stocks: - Common Shares: These are the most typical type of stock. They often come with voting rights at annual general meetings but offer no guarantee of returns. - Preferred Shares: These shares generally provide fixed dividends and have a higher claim on assets in the event of liquidation, but typically lack voting rights. Se la compagnia andasse in fallimento, la compagnia dev-e prima ripagare chi ha questi stock e poi quelli ordinari sempre che gli rimangono dei soldi per questo.  - Savings Shares: Issued primarily by financial institutions, these may have specific features different from common or preferred stocks. Sono gli unici che hanno assolutamente il diritto dei dividendi, gli altri non per forza. - Multiple-Vote Shares: These provide enhanced voting rights compared to common shares, often giving significant control to major shareholders. Dual and Multiple Listings: Companies may choose to list their shares on more than one stock exchange, known as dual or multiple listings. This strategy is intended to increase the company's visibility and potentially boost the demand for its stock. Market Capitalization Market capitalization, often referred to as market cap, represents the total value of a company's outstanding shares in the market. It serves as a straightforward indicator of a company's size. Market capitalization is calculated by multiplying the total number of outstanding shares by the current share price. For instance, if a company has 7 billion shares outstanding valued at 10 Euros each, its market capitalization would be: Market Cap = 7 billion shares×10 Euros/share = 70 billion Euros Importance of Portfolio Diversification Risk diversification in investing involves incorporating a wide variety of financial instruments within a portfolio. This strategy aims to include assets with uncorrelated returns over time. The primary goal of a diversified portfolio is to limit exposure to specific risks associated with any single financial asset. Historically, portfolios that consist of different types of financial instruments—across various asset classes and geographies—tend to produce higher long-term returns on average while reducing overall portfolio risk. One period valuation model: Buying the Stock: Purchase the stock and hold it for one period to receive a dividend. Selling the Stock: Sell the stock at the end of the period. To decide whether to buy Amazon shares, you need to evaluate if the current price reflects the analyst's forecast. To value the stock today, compute the present discounted value of the expected cash flows 𝐷𝑖𝑣1 𝑃1 using the following formula: 𝑃0 = (1+𝑘𝑒) + (1+𝑘𝑒) Ke: Required return on equity investment. The one-period dividend valuation model can be extended to any number of periods. You have to find Pn in order to find P0. However, if Pn is far in the future, it will not affect P0. This means that the current value of a share of stock can be found as simply the present value of the future dividend stream. The Gordon Growth Model relies on two main assumptions: - Constant Dividend Growth: Dividends are assumed to grow at a constant rate indefinitely. Errors related to distant future cash flows become negligible when discounted to the present. - Growth Rate Less Than Required Return: The growth rate (g) is assumed to be less than the required return on equity (k). This assumption is reasonable because if the growth rate were higher than the required return, the firm would eventually become unmanageably large in the long 𝐷0×(1+𝑔) 𝐷1 run. 𝑃0 = (𝑘𝑒−𝑔) = (𝑘𝑒−𝑔) Price-Earnings valuation method: The Price-Earnings (P/E) valuation method is used to gauge how much the market is willing to pay for $1 of a firm's earnings. A high P/E ratio can have two interpretations: 1. Growth Expectation: A higher-than-average P/E might indicate that the market expects future earnings to rise, which would normalize the P/E ratio over time. 2. Low Risk Premium: Alternatively, a high P/E might suggest that the market perceives the firm's earnings as very low-risk and is therefore willing to pay a premium. The P/E ratio can be employed to estimate a firm’s stock value. Firms within the same industry typically have similar P/E ratios in the long run. However, specific firm-related factors that could influence the long-term P/E ratio are often ignored. A skilled analyst will adjust the P/E ratio to reflect a firm's unique characteristics when estimating its stock price. How the market sets security prices: The market sets the price of a security based on the highest bid from a buyer. This price isn't necessarily the maximum the asset could fetch, but it is slightly higher than what other buyers are willing to pay. The buyer who can make the most productive use of the asset usually sets the market price. Information plays a critical role in asset pricing. Superior information about an asset can enhance its value by reducing perceived risk. When considering purchasing a stock, uncertainties about future cash flows exist, and a well-informed buyer will discount these cash flows at a lower interest rate than someone who is less informed. As new information is released about a firm, expectations and prices shift. Changes in expectations about future dividends or their risks can cause price fluctuations. Because market participants are continuously receiving new information and updating their expectations, stock prices are in constant flux, contributing to market volatility. Errors in stock price evaluation: Errors in stock price valuation can stem from difficulties in estimating growth, evaluating risk, and forecasting dividends. Competition can prevent high-growth firms from maintaining their historical growth rates, as seen during the technology stock bubble. Stock prices are highly dependent on the required return, which can fluctuate based on various factors. The dividend payout ratio is influenced by the firm's future growth opportunities and management’s concerns about future cash flows. Information indicating that the economy is slowing can lead analysts to revise their growth expectations, which in turn causes significant stock price fluctuations. Case study: market shocks 11/09/01 The September 11 terrorist attack raised fears that terrorism could paralyze the United States, leading to a downward revision of growth prospects for U.S. companies. This lowered the dividend growth rate (g) in the Gordon model, causing an increase in the denominator of the equation and a decline in stock prices (P0). Additionally, the increased economic uncertainty led to a higher required return on equity (ke), further increasing the denominator in the Gordon equation and contributing to a general fall in stock prices. As the Gordon model predicts, the stock market fell by over 10% immediately after the attack. The FTSE MIB Index: A stock market index is used to monitor the behavior of a group of stocks, providing insights into how a broader group of stocks may have performed. Various indices are reported globally to give investors an indication of performance across different baskets of stocks. The FTSE MIB Index is a benchmark index for the Italian equity markets, derived from stocks trading on the Borsa Italiana. It measures the performance of 40 shares listed on Borsa Italiana, aiming to replicate the broad sector weights of the Italian stock market. The index is market capitalization weighted, with individual stock weights capped at 15%. Regulation of the italian financial market: CONSOB is the supervisory authority for the Italian financial products market, responsible for protecting investors and ensuring the efficiency, transparency, and development of the market. Key functions include: - Regulating investment services and activities by intermediaries, and overseeing the reporting obligations of companies listed on regulated markets. - Monitoring market management companies and the transparency of negotiations, ensuring the correct conduct of intermediaries and approved persons.  - Checking information disclosed to the market by entities, ensuring the accuracy of accounting documents. - Identifying anomalies in the trading of listed securities and taking necessary actions to prevent insider trading and market abuse. How firms issues securities: Firms often need to raise new capital to finance their investment projects. They can do this by either borrowing money or selling shares in the firm. - Investment bankers are usually hired to manage the sale of these securities in the primary market, where newly issued securities are sold. - Secondary markets are where trades of existing securities take place. - Shares of publicly listed firms are traded continuously on well-known markets like NYSE and Nasdaq in the U.S., and Euronext, Deutsche Boerse, and London Stock Exchange in Europe. - Such companies are often referred to as publicly traded, publicly owned, or simply public companies Privately held firms: A privately held company is owned by a relatively small number of shareholders. Such firms have fewer obligations to release financial statements and other public information, which saves costs and avoids disclosing competitive information. Additionally, eliminating quarterly earnings announcements can provide the flexibility to pursue long-term goals without shareholder pressure. - When private firms need to raise funds, they often do so through private placements, selling shares directly to a small group of institutional or wealthy investors. - In the USA, the SEC allows these placements without requiring the extensive and costly registration statements that public companies must prepare. - However, shares of privately held firms do not trade in secondary markets, such as a stock exchange, which significantly reduces their liquidity and likely lowers the prices that investors are willing to pay. Alcune compagnie come la Ferrero, non necessitano di essere quotate in borsa perchè hanno già i soldi. Oppure altre compagnie non vogliono diventare pubbliche perché se sei una public company devi rispettare certi canoni, ad esempio gli financial statements e la disclosure di alcuni documenti, quindi a volte non essere una compagnia quotata è anche meglio perchè così non devi raccontare i fatti tuoi. Public Traded company: When a private firm decides to raise capital from a wide range of investors, it may choose to go public. This involves selling its securities to the general public, allowing investors to trade these shares on established securities markets. - The first issue of shares to the public is called an Initial Public Offering (IPO). The firm may later issue additional shares through a seasoned equity offering. - Public offerings of stocks and bonds are typically managed by investment bankers, who serve as underwriters. A lead firm forms an underwriting syndicate with other investment banks to share the responsibility for the issuance. Investment bankers advise the firm on the terms of the securities sale. A preliminary registration statement is filed with the SEC, and once finalized, it is called the prospectus. At this stage, the offering price is announced. After SEC comments, roadshows are organized globally to generate interest and gather pricing information. This process, known as book-building, involves polling potential investors to gauge demand and adjust the offering price and quantity of shares accordingly. The book created during this process is valuable, providing insights into market demand and the firm's prospects. Ad esempio poste italiane sono al 35% dello stato, quindi se le poste vendono degli shares, cosa che sta succedendo ora, anche lo stato otterrà fondi e quindi questa è un ottima strategia per ottenere capitale. In pratica poste italiane vende gli stock a diverse banche nel mondo e poi è il compito delle banche di vendere questi shares agli investitori di quella banca. Quando la ferrari è diventata quotata in borsa nel 2015 hanno creato questo prospectus di 252 pagine nel quale ci sono: risk factors, dividends policies, capitalization and debts, board of directors and their skills, the characteristics of the share. Quando il prospectus è pronto i manager e le banche iniziano a girare per circa 2 settimane e incontrano i potenziali investitori, è importante perchè si prendono delle informazioni dagli investitori, come ad esempio il prezzo e la percentuale a cui vorrebbero comprare gli shares ecc. Dopo tutti questi viaggi si fa il book building ovvero si mettono tutti insieme le informazioni apprese dagli investitori. Il prezzo al quale verranno venduti gli shares è il punto di equilibrio tra la supply e la demand, la domanda sono gli shareholders e la la supply è la firma che ovviamente vuole vendere meno shares ad un prezzo maggiore mentre gli shareholders vogliono comprare più shares al minor prezzo. Gli ipo poi vengono venduti subito a quel prezzo deciso, ma se io penso che il prezzo è troppo alto e scenderà posso aspettare a comprarlo. Initial Public Offering (IPO) An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time, transitioning to a publicly traded company. This process involves issuing new shares and listing them on a stock exchange to raise capital from investors. The IPO Underpricing Effect In an IPO, shares are allocated based on investor interest, and firms must demonstrate their optimism to secure a significant allocation. To attract investors and gather essential information, underwriters often set the IPO price below its market value, resulting in underpricing. This phenomenon is visible in the price jumps observed on the first trading day. For instance, Groupon’s IPO in November 2011 saw its shares rise over 30% from the offering price. However, not all IPOs are underpriced; Facebook’s 2012 IPO is a notable example where shares fell 15% below the offer price soon after and dropped to half the price within five months. Ci sono alcuni casi, dove gli stock vengono messi a un basso prezzo durante l’ipo, per esempio a 10 euro invece che 12 euro, se io voglio comprare veramente quella azione, tutti quanti si metteranno a comprare le azioni alle 9 di mattina e così i prezzi delle azioni aumenteranno perché ora tutti la vogliono, quindi è per questo che all’inizio magare gli IPO sono più bassi. China Case Study: Between 1991 and 2003, Chinese IPOs on the Shanghai and Shenzhen exchanges had an average underpricing of around 175% on the first trading day. Major factors influencing these high returns include government intervention, market speculation, special ownership structures, and strategies aimed at maximizing proceeds while managing risk. The IPO as a “Market Access” Strategy On June 24, 2011, Prada conducted a $2.14 billion IPO in Hong Kong to enhance its brand awareness in China, the fastest-growing luxury market. The decision to list in Hong Kong was driven by its fewer regulations and its proximity to Chinese investors, reflecting a common strategy among luxury brands that rely on Chinese consumption for growth. Prada ha deciso nel 2011 di essere quotata nella borsa di hong kong, questo perchè non volevano che le grosse aziende avessero la maggior parte del loro capitale, e hanno preferito quindi avere più investitori che hanno minor parte dell’azienda, inoltre questa è anche una strategia di mercato in quanto per essere quotata là tu devi avere un headquarter lì e dei negozi e di fatto così si sono espansi. The Actors in Stock Trading The Stock Exchange is the primary marketplace for trading stocks. Individuals wishing to buy or sell securities must go through authorized intermediaries, such as banks and securities brokerage firms. These intermediaries send buy and sell orders to the market on behalf of individual investors. Institutional Investors: Large organizations that invest significant amounts of capital. Intermediaries (Banks and Brokers): Facilitate transactions between buyers and sellers. Private Investors: Individual investors purchasing shares for personal investment. Investment Funds: Pool capital from multiple investors to buy securities. Corporates: Companies whose shares are traded on the stock exchange. How to Buy Shares Using Financial Intermediaries: To buy shares, one must engage a financial intermediary, like a bank or an online broker, which facilitates buying and selling on regulated markets. Online Trading Accounts: Most brokers provide online trading accounts, enabling users to buy and sell stocks via web or mobile platforms. To start, you need to open a securities deposit account with your chosen intermediary. Commission Profile: When selecting a broker, consider the commission structure, which may vary based on trading frequency, financial instruments, and transaction amounts. Types of Commissions: - Fixed Commissions: A set fee for each transaction, regardless of the transaction size. - Percentage Commissions: Fees based on a percentage of the total transaction value. - Degressive Commissions: A fee that decreases as the number of trades increases How Securities Are Traded: Types of Markets: Securities can be traded in different venues, primarily through Regulated Exchanges or Over-the-Counter (OTC) markets. While some stocks are traded OTC, most trading volume occurs on Regulated Exchanges or Multilateral Trading Facilities (MTFs). Regulated Exchanges are known for their transparency and provide guaranteed trading venues. In contrast, OTC markets are less transparent and often used for accommodating large trades. Market Makers play a crucial role in trading by continuously quoting bid prices (prices they are willing to pay) and ask prices (prices they are willing to sell at). The difference between these prices, known as the bid-ask spread, compensates market makers for providing continuous liquidity. For a stock to be listed on an organized exchange, a company must meet specific criteria designed to enhance trading procedures and transparency. When investors want to buy or sell shares, they typically place an order through a brokerage firm, which charges a commission for facilitating the trade. Types of Orders 1. Market Orders: These are buy or sell orders executed immediately at the current market price. 2. Limit Orders: Investors can place orders specifying the price at which they wish to buy or sell a security. 3. Stop Orders: These orders are executed only when a stock reaches a certain price limit. Stop-loss orders trigger a sale if the stock price falls below a predefined level, helping to limit losses. Stop orders are often used in conjunction with short sales (selling borrowed securities) to manage potential losses. Trading Order-Book The Trading Order-Book is a real-time virtual representation of the market for a specific stock, displaying all active buy and sell orders. The order book is divided into two sections: - Left Side (BID): Displays purchase proposals, including their respective prices and quantities. - Right Side (ASK): Displays sales proposals, showing the asking prices and quantities. Orders are organized based on price: - Bid Side: Arranged in descending order (highest prices at the top). - Ask Side: Arranged in ascending order (lowest prices at the top). The market price of a stock is determined by the best buyer, who is willing to pay the highest price at any given time. Modern Trading Technology Today, stock exchanges operate as fully electronic markets. Technology has enabled traders to quickly compare prices across markets and direct trades to the venues offering the best prices. This advancement has dramatically reduced trade execution costs. The integration of electronic trading and computer science has revolutionized trading strategies. Algorithmic trading now allows computer programs to initiate and execute orders in milliseconds, a significant leap from the manual trading practices of the past. Short Selling: Short selling is a trading strategy where an investor sells shares they do not own, with the intention of buying them back later at a lower price. Here’s how it works: - Sell Short: The investor borrows shares from a broker and sells them at the current market price. The proceeds from this sale are credited to the investor’s account. - Cover the Position: To close the short sale, the investor must buy back the same number of shares at a later time and return them to the broker. The goal is to buy back at a lower price than the selling price. Profit: The profit is calculated as the difference between the initial sale price and the repurchase price, minus any dividends paid and interest on the borrowed shares. Example: If you short 1,000 shares of XYZ at $100 each, you receive $100,000. If the price drops to $70 per share, you buy back the 1,000 shares for $70,000. Your profit is $30,000, which is the difference between the selling and buying prices. Stop Orders can be used to limit potential losses if the stock price rises instead of falling. Private Equity: Venture Capital Firms In private equity, capital is raised through a limited partnership with a small group of wealthy investors, rather than through public markets. The main types of private equity are venture capital and capital buyouts. Firms like Bain Capital and Blackstone Group often operate in both areas. Venture capital is essential for funding new and unproven businesses that can't secure loans from banks or go public. For instance, if you have a groundbreaking idea but lack an established track record, venture capitalists can provide the necessary funds to help you get started. These firms invest in early-stage companies, acting as seed investors. Venture capitalists have played a key role in the success of major tech companies, such as Apple, Cisco, and Microsoft Venture Capital Firms Venture capital firms address the information gap in financing by providing equity investment rather than loans or bonds. Unlike publicly traded stocks, equity in these privately held firms is illiquid, necessitating a long-term investment horizon. To mitigate risks and ensure active involvement, venture capitalists often take board seats and contribute advice, assistance, and business contacts. They may also facilitate strategic connections between firms to enhance value and solve growth-related issues. Venture capital firms raise funds from pension funds, corporations, and wealthy individuals. They often face a long investment horizon, with capital tied up for 7 to 10 years. The funds may specialize in specific industries or geographical regions to streamline monitoring and investment. Investments can be categorized into seed investing (early, often pre-product stage), early-stage investing (firms with some development), and later-stage investing (helping firms prepare for public financing). The goal is to nurture firms until they can secure alternative funding sources. Exits are typically through initial public offerings (IPOs) or mergers and acquisitions (M&As), where the venture firm receives stock or cash that is distributed to investors. Given the high-risk nature of venture investing, successful exits can yield significant returns to attract and retain investors Early phase: se hai una bella idea ma ti servono i soldi allora crei una startup e inizi a vendere i tuoi prodotti, in questo stadio sei in perdita Expansion phase: inizi a scalare e crei un pre-IPO Public to private: a questo punto eri nello stock market, a volte invece i tuoi stock vengono comprati da competitors o aziende private che vogliono aumentare il loro capitale e dunque queste startup ritornano private sotto un’altra azienda. Private Equity Buyout A private equity buyout involves taking a public company private, rather than the reverse. In this process, a limited partnership buys out the publicly traded shares of a company, effectively removing it from public scrutiny and regulatory oversight. Here's how it typically works: 1. Formation and Purchase: A private equity firm forms a partnership, attracts investors, and identifies an underperforming public company. Using funds from the investors, the firm buys all outstanding public shares, taking the company private. 2. Management Changes: The private equity firm replaces the company’s management, including appointing a new CEO and board. The managing partners often take an active role in running the company. 3. Revival and Exit: The goal is to revive the company, improving its revenues and profitability. Once the company is in better shape, it is either sold to another firm or taken public again through an initial public offering (IPO). The improved performance typically allows for a higher selling price, thus providing returns to the investors. Macroeconomics and industry analysis: The intrinsic value of a stock is determined by its expected dividends and earnings, which are central to fundamental analysis. This method assesses a firm's value based on its future earnings potential and the dividends it can provide. Ultimately, the firm's business success drives both its dividend payments and its market price. Macroeconomic and Industry Factors: A firm's performance is influenced by the broader economic environment. For some companies, macroeconomic and industry conditions may impact profits more than the firm's own performance. Thus, investors should consider the big economic picture when evaluating a stock. Analytical Approach: Start by analyzing the aggregate economy and international factors. Next, assess the industry in which the firm operates. Finally, examine the firm's position within the industry to understand its prospects. The global Economy: A top-down analysis begins with evaluating the global economy to understand how international factors might influence a firm's performance. For instance, global economic conditions, such as political instability in countries like Greece or Italy in 2012, can affect a firm's export opportunities, price competition, and profitability from overseas investments. Key Economic Indicators: - Gross Domestic Product (GDP) measures the total output of goods and services in an economy. A rising GDP typically indicates a growing economy, which can be favorable for businesses. - Unemployment Rate shows how much of the labor force is actively seeking work. A low unemployment rate often reflects a healthy economy with potential for increased consumer spending. - Inflation is the rate at which prices for goods and services rise. Moderate inflation is normal in a growing economy, but high inflation can erode purchasing power and impact business costs. - Interest Rates: High interest rates increase the cost of borrowing, reducing the present value of future cash flows and making investments less attractive. Real interest rates, which adjust for inflation, are particularly important in determining the feasibility of business investments.  - Budget Deficit: The difference between government spending and revenue. A significant deficit can lead to increased government borrowing, which may drive up interest rates and crowd out private investment. - Sentiment: The optimism or pessimism of consumers and producers affects economic performance. High consumer confidence generally leads to increased spending, while business confidence can spur investment and production. Federal Government Policy: Fiscal Policy involves government spending and taxation decisions. It is a direct tool for influencing economic activity. A large government deficit, indicating high spending relative to tax revenue, can stimulate the economy in the short term but may lead to higher interest rates and reduced private investment in the long term. Monetary Policy refers to the management of the money supply and interest rates by central banks. Increasing the money supply can lower short-term interest rates and boost investment and consumption. However, if overused, it can lead to higher inflation without sustainable long-term economic growth. Business Cycles: Expansion and Contraction: The economy experiences alternating periods of growth (expansion) and decline (contraction). Understanding where the economy is in this cycle helps in predicting the performance of various industries. Peaks occur at the end of an expansion phase before a contraction begins, while troughs mark the lowest point of a recession before recovery starts. Industry Analysis: - Cyclical Industries: Sectors such as automobiles and durable goods are highly sensitive to economic cycles. As the economy begins to recover from a recession, these industries often see significant growth and perform well. - Defensive Industries: Sectors like food production, pharmaceuticals, and public utilities are less affected by economic downturns. These industries tend to perform better during recessions because their products and services are always in demand, regardless of economic conditions. The efficient market Hypothesis: The Efficient Market Hypothesis (EMH) suggests that security prices in financial markets fully reflect all available information. This implies that the current prices are set so that the optimal forecast of a security’s return, using all available information, equals the security’s equilibrium return. In an efficient market, all unexploited profit opportunities are quickly eliminated, meaning that even if not everyone is well-informed, the market still reaches efficiency. Food for thoughts around market efficiency: Stock prices tend to respond to announcements only when the information is new and unexpected. This means that even when good news is announced, stock prices may sometimes decline, which is consistent with the efficient market hypothesis. In theory, stock prices should reflect market fundamentals, which are factors that directly impact the future income streams of securities. This supports the idea that financial markets are efficient. However, the occurrence of market crashes and bubbles, where asset prices rise significantly above their fundamental values, casts doubt on the stronger interpretation of market efficiency. These events suggest that prices do not always reflect the intrinsic value and all available information. ESG Framework for Investors: Why Invest Responsibly? 1. Materiality: Recognizes that ESG factors can affect risk and return, gaining attention in the financial industry and academia. 2. Market Demand: There is a growing demand from clients and beneficiaries for greater transparency in how money is invested. 3. Regulation: Guidance from regulators emphasizes that considering ESG factors is part of investors' duties to their clients. Examples of ESG Factors: Environmental: Climate change, resource depletion, pollution, deforestation. Social: Human rights, labor conditions, child labor, employee relations. Governance: Bribery, executive pay, board diversity, tax strategy Why Materiality Matters - Scandals often result from governance failures, which can have significant financial consequences. This underscores the importance of transparency for investors. - A lack of a strong materiality process, including Board of Directors oversight and ongoing monitoring, might indicate inadequate governance controls and procedures, serving as a red flag for potential scandals. Case Study: Volkswagen AG In 2015, it was revealed that Volkswagen had installed technology in its US diesel cars to cheat on emissions testing. TDI diesel engines were programmed to activate emissions controls only during lab tests, while real-world NOx emissions were 40 times higher than reported. Prior to the scandal, Volkswagen had repeatedly reduced reporting on air emissions in their sustainability reports. They also faced difficulties in producing their Sustainability Report 2015 promptly after the scandal. The damage to their reputation led Volkswagen to rebrand from “Most sustainable automotive company in the world” to “Leading provider of sustainable mobility” post-scandal. Case Study: Boeing On October 29, 2018, Lion Air Flight 610 crashed into the Java Sea, killing all 189 on board. On March 10, 2019, Ethiopian Airlines Flight 302 also crashed, resulting in 157 fatalities. Both incidents involved Boeing 737 MAX 8 aircraft. An examination of Boeing’s financial reports showed that the company seldom addressed product and service safety compared to its peers, highlighting a significant transparency gap in its public reporting. The crashes were linked to several factors: the new, larger engine on an older airframe altered aerodynamic properties; a faulty sensor failed to prevent stalling; and pilot training was inadequate. These safety issues were likely preventable, and Boeing’s lack of transparency might have been a warning sign. In response, Boeing stated, “Safety is a core value at Boeing, and it always will be. We are doing everything we can to understand the cause of the accidents, deploy safety enhancements, and ensure this does not happen again” (Boeing Company, 2019). Behavioral Finance vs. Efficient Market Hypothesis The Efficient Market Hypothesis (EMH) posits that: 1. Security prices reflect all available information. 2. Active traders struggle to outperform passive strategies, like holding market indexes. Behavioral finance challenges this view, arguing that even if security prices are not always correct, exploiting them can still be difficult. This challenges the notion that failure to find successful trading rules proves market efficiency. Behavioral finance assumes investors are irrational, unlike traditional theories which assume rationality. Behavioral biases include:  Forecasting Errors: People overemphasize recent experiences and make overly extreme forecasts, such as high price-to-earnings ratios. Overconfidence: Individuals overestimate their abilities and the accuracy of their forecasts. For example, men, particularly single men, trade more actively than women, reflecting greater overconfidence and often poorer performance. Conservatism Bias: Investors are slow to up