Foundations of Global Financial Markets and Institutions PDF

Foundations of Global Financial Markets and Institutions Fifth Edition Frank J. Fabozzi and Frank J. Jones With Francesco A. Fabozzi and Steven V. Mann The MIT Press Cambridge, Massachusetts London, England © 2019 Massachusetts Institute of Technology All rights re...

Foundations of Global Financial Markets and Institutions Fifth Edition Frank J. Fabozzi and Frank J. Jones With Francesco A. Fabozzi and Steven V. Mann The MIT Press Cambridge, Massachusetts London, England © 2019 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. This book was set in Times Roman by Westchester Publishing Services. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Names: Fabozzi, Frank J., author. | Jones, Frank Joseph, author. Title: Foundations of global financial markets and institutions / Frank J. Fabozzi and Frank J. Jones ; with Francesco A. Fabozzi and Steven V. Mann. Other titles: Foundations of financial markets and institutions Description: Fifth edition. | Cambridge, MA : MIT Press, | Earlier editions published as: Foundations of financial markets and institutions. | Includes bibliographical references and index. Identifiers: LCCN 2018026996 | ISBN 9780262039543 (hardcover : alk. paper) Subjects: LCSH: Finance. | Financial institutions. Classification: LCC HG173.F29 2019 | DDC 332.1—dc22 LC record available at https://lccn.loc.gov/2018026996 To the memory of my sister, Lucy Fabozzi. —FJF To my wife, Sally. —FJJ Contents Preface Acknowledgments Overview of the Book I Financial Markets and Players 1 Introduction 2 Role of Governments in Financial Markets 3 Financial Institutions, Financial Intermediaries, and Asset Management Firms 4 Overview of Private Market Participants 5 Credit Rating Agencies and Their Role in Financial Markets 6 Depository Institutions: Activities and Characteristics 7 Central Banks 8 Insurance Companies 9 Investment Banking Firms II Understanding Risks and Asset Pricing 10 Overview of Risks and Their Management 11 Properties and Pricing of Financial Assets 12 Return Distributions, Risk Measures, and Risk-Return Ratios 13 Portfolio Selection Theory 14 Asset Pricing Theories III Interest Rates, Interest Rate Risk, and Credit Risk 15 The Theory of Interest Rates 16 The Structure of Interest Rates IV Primary and Secondary Markets 17 Primary Markets 18 Secondary Markets  19 The Foreign Exchange Market V Global Government Debt Markets 20 Sovereign Debt Markets 21 Subnational (Municipal) Government Debt Markets VI Corporate Funding Markets 22 The Structure and Trading Venues of the Equity Market 23 U.S. Common Stock Market: Pricing Efficiency, Trading, and Investment Strategies 24 Non-U.S. Equity Markets 25 Global Short-Term Funding and Investing Markets 26 Corporate Debt Markets 27 Market for Asset-Backed Securities 28 Financing Market for Small, Medium-Sized, and Entrepreneurial Enterprises VII Real Estate Markets 29 The Residential Mortgage Market 30 Residential Mortgage-Backed Securities Market 31 Commercial Real Estate Markets VIII Collective Investment Vehicles and Financial Derivatives Markets 32 Market for Collective Investment Vehicles 33 Financial Futures Markets 34 Options Markets 35 Pricing Futures and Options Contracts 36 Applications of Futures and Options Contracts 37 Over-the-Counter Interest Rate Derivatives: Forward Rate Agreements, Swaps, Caps, and Floors 38 Market for Foreign Exchange Derivatives 39 Market for Credit Risk Transfer Vehicles Index List of Figures Figure 1.1 Classification of global financial markets. Figure 8.1 Insurance/savings/retirement vehicles. Figure 12.1 Negative (top panel) and positive (bottom panel) skewed probability distributions. Figure 12.2 Normal (Gaussian) probability distribution; σ denotes the standard deviation. Figure 12.3 Difference between a standard normal distribution and a distribution with high excess kurtosis. Figure 12.4 S&P 500 monthly returns plotted against a normal distribution: (a) S&P 500 monthly returns from 1970 to 2015; (b) S&P 500 monthly returns from 1980 to 2015; (c) S&P 500 monthly returns from 1990 to 2015. Figure 12.5 DAX returns plotted against a normal distribution, 1991–2015: (a) DAX monthly returns; (b) DAX daily returns. Figure 12.6 Nikkei 225 returns plotted against a normal distribution, 1990–2015: (a) Nikkei 225 monthly returns; (b) Nikkei 225 daily returns. Figure 12.7 FTSE 100 returns plotted against a normal distribution, 1990–2015: (a) FTSE 100 monthly returns; (b) FTSE 100 daily returns. Figure 12.8 Illustration of the value-at-risk (VaR) measure. Figure 13.1 Feasible and efficient portfolios for assets 1 and 2. Figure 13.2 Feasible and efficient portfolios with more than two assets. Figure 13.3 Selection of the optimal portfolio. Figure 13.4 Selection of the optimal portfolio with different indifference curves (utility function). Figure 14.1 The capital market line. Figure 14.2 Systematic and unsystematic portfolio risk. Figure 14.3 Graphical depiction of the market model. Figure 14.4 The security market line. Figure 15.1 Indifference curve between current and future consumption. Figure 15.2 Representation of opportunity locus in the loan market (the market line). Figure 15.3 Family of indifference curves and the market line. Figure 15.4 Supply curve for loans. Figure 15.5 Opportunity locus from investment (transformation curve or production function). Figure 15.6 Measuring the profit from investing. Figure 15.7 Profit maximization point. Figure 15.8 Profit maximization and the cost line. Figure 15.9 Transformation curve imposed on current and future consumption graph. Figure 15.10 Measuring investment and profit from investment. Figure 15.11 Optimal investment and borrowing decisions. Figure 15.12 Market equilibrium. Figure 15.13 Change in I, S, and R if investment function increases. Figure 15.14 Change in I, S, and R if saving function increases. Figure 15.15 Equilibrium in Keynes’s market for money. Figure 16.1 Three hypothetical yield curves. Figure 16.2 Two alternative one-year investments. Figure 22.1 Structure of U.S. stock markets. Figure 22.2 U.S. equity trading venues. Figure 24.1 The Chinese stock market and exchanges: (a): structure of the Chinese stock market; (b) Chinese stock exchanges; (c) Chinese stock indexes. Figure 30.1 Creation of a mortgage pass-through security. Figure 30.2 Graphical depiction of 100 PSA. Figure 31.1 Subordination (credit support), priority of payment, and order of loss allocation for Banc of America Commercial Mortgage Trust 2006-1. Figure 34.1 Profit/loss profile for a long call position. Figure 34.2 Profit/loss profile for a short call position. Figure 34.3 Profit/loss profile for a long put position. Figure 34.4 Profit/loss profile for a short put position. Figure 35.1 One-period option pricing model. Figure 35.2 One-period option pricing model illustration. Figure 37.1 Interest rate swap for debt issuance. Figure 38.1 Outcome of two alternatives: determination of theoretical forward rate. Figure 38.2 A currency swap example. Figure 39.1 Categorization of credit derivatives. Figure 39.2 Mechanics of a single-name credit default swap with physical delivery. Figure 39.3 Mechanics of a credit default swap index with physical delivery. List of Tables Table 1.1 Summary of classification of financial markets. Table 2.1 U.S. Government bailouts by type. Table 3.1 Nature of liabilities of financial institutions. Table 5.1 Summary of corporate bond ratings systems investment grade: high creditworthiness. Table 5.2 A hypothetical average one-year rating migration table. Table 6.1 Elements of CAMELS bank ratings. Table 7.1 The 19 central banks of the member countries of the G20. Table 7.2 Some basic differences in banking systems around the world. Table 7.3 Bank supervisory criteria for assessing systemic risk. Table 8.1 Largest life insurers in the United States, Europe, and Asia. Table 8.2 Classification of cash value insurance. Table 11.1 Price of a four-year bond for various discount rates. Table 11.2 Price of a bond paying $50 annually and $1,000 at maturity for various discount rates and maturities. Table 11.3 Price decline if the discount rate increases 100 basis points for a bond paying $50 annually and $1,000 at maturity for various discount rates and maturities. Table 11.4 Determination of duration for a 5% coupon bond with a principal of $1,000 and an initial required yield of 9%. Table 11.5 Duration for various bonds by maturity, coupon rate, and yield level. Table 13.1 Portfolio expected returns and standard deviations for five asset allocations for assets 1 and 2. Table 14.1 Beta estimates for five stocks on August 3, 2018, from Yahoo Finance. Table 16.1 Maturity and yield to maturity for 20 hypothetical Treasury securities. Table 16.2 Theoretical spot rates. Table 16.3 Illustration of how to value a 10-year, 10% Treasury bond using spot rates. Table 16.4 U.S. Treasury yield curve for five dates. Table 17.1 Illustration of an auction for an IPO. Table 19.1 ISO 4217 currency codes for selected countries. Table 19.2 2016 Currency distribution of global FX market turnover, top eight currencies. Table 19.3 2016 top eight global FX market turnover by currency pair: Daily averages. Table 20.1 Central government debt securities outstanding in Billions of U.S. Dollars as of year end, 2016. Table 20.2 Maturities of short-term debt for selected countries. Table 20.3 Maturities for coupon debt securities 2–30 years and availability of stripping, selected countries. Table 20.4 Comparison between a traditional bond and an inflation-adjusted bond. Table 20.5 Price auction illustration. Table 20.6 Total payments of a 2% gilt to be stripped. Table 22.1 Trading stock markets: Then and now. Table 22.2 Quote-driven/dealer market. Table 23.1 Stock weights by index weighting methods—hypothetical data. Table 23.2 Stock index weighting methods—actual data. Table 23.3 Conditional orders and the direction of triggering security price movements. Table 24.1 Country composition of the FTSE Global All Cap Index, April 30, 2017. Table 24.2 Global stock indexes. Table 24.3 Twenty largest global stock exchanges by market capitalization, January 31, 2015. Table 24.4 The Chinese Stock Exchanges (as of January 31, 2015). Table 24.5 Chinese share types. Table 25.1 Central bank rates. Table 25.2 Commercial paper ratings. Table 28.1 Various definitions of SMEs. Table A29.1 Amortization schedule. Table 30.1 Monthly cash flow for a $400 million pass-through security (assuming 100 PSA). Table 30.2 Monthly cash flow for a $400 million pass-through security (assuming 165 PSA). Table 30.3 CMO-1: Hypothetical four-tranche, sequential-pay structure. Table 30.4 Monthly cash flow for selected months for CMO-1 (assuming 165 PSA). Table 30.5 Average life for the collateral and the four tranches of CMO-1 (years). Table 30.6 CMO-2: Hypothetical four-tranche sequential-pay structure with an accrual bond class. Table 30.7 Monthly principal payment for $400 million, 7.5% coupon pass-through (assuming prepayment rates of 90 PSA and 300 PSA). Table 30.8 CMO-3 structure with one PAC bond and one support bond. Table 30.9 Average life for PAC bond and support bond in CMO-3, assuming various prepayment speeds (years). Table 31.1 CMBS deal: Banc of America Commercial Mortgage Trust 2006-1. Table 34.1 Profit/loss profile for a long call position. Table 34.2 Comparison of long call position and long asset position. Table 34.3 Profit/loss profile for a long put position compared to a short asset position. Table 35.1 Profit/loss profile for a strategy involving a long position in Asset XYZ, short call option position, and long put option position. Table 35.2 Summary of factors that affect the price of an option. Table 35.3 Option chain on August 15, 2016, for Apple Inc (APPL) put and call option expiring on March 17, 2017 (APPL Price = $109.48). Table 35.4 Option chain on August 14, 2016, for Apple Inc (APPL) put and call options with a strike price of 105 for different expiration dates. Table A36.1 A hedge that locks in the current price of palladium: Cash price decreases. Table A36.2 A hedge that locks in the current price of palladium: Cash price increases. Table A36.3 Hedge: Cash price decreases and basis widens. Table A36.4 Hedge: Cash price increases and basis widens. Table A36.5 Cross-hedge: Cash price of kryptonite to be hedged and price of futures used decreased by same percentage. Table A36.6 Cross-hedge: Cash price of kryptonite to be hedged falls by a greater percentage than the futures used for the hedge. Table A36.7 Cross-hedge: Cash price of kryptonite to be hedged falls and the price of futures used for the hedge rises. Table 37.1 Effect of rate changes on parties to an FRA and an interest rate futures contract. Table 37.2 Risk/return profile of counterparties to an interest rate swap. Table 37.3 Effect of rate changes on interest rate swap counterparties and FRA counterparties. Table 37.4 Effect of rate changes on interest rate swap counterparties, FRA counterparties, and futures and forwards on fixed-income instrument counterparties. Table 37.5 Cash flow for the purchase of a five-year, floating-rate bond financed by borrowing on a fixed-rate basis. Table 38.1 Global FX derivative daily turnover, 2016 (billions of U.S. dollars). Preface The first edition of this book, published in 1994, was written by Frank Fabozzi and Franco Modigliani, the 1985 recipient of the Nobel Memorial Prize in Economic Sciences. In the Preface to the first edition, they wrote that the prior 30 years had been a time of profound, indeed revolutionary, change in the financial markets and institutions of the world. The hallmarks of that change were innovation, globalization, and deregulation. Since 1994, those forces have actually gathered more strength, and the financial landscape continues to undergo large and visible changes around the globe. Their purpose in writing the book was to instruct students about this fascinating revolution. They described the wide array of financial instruments that are now available for investing, funding operations, and controlling the wide range of financial risks. Each type of financial instrument was shown to be a response to the needs of borrowers, lenders, and investors, who manage assets and liabilities in a world of constantly changing interest rates, asset prices, regulatory constraints, and international competition and opportunities. The book devoted a considerable amount of space to explaining how the world’s key financial institutions manage their assets and liabilities and how innovative financial instruments support that management. The focus on the actual practices of financial institutions was particularly beneficial to students who will inevitably have to respond to changes in those institutions and their environment. This is the fifth edition of the book. The fourth edition was published in 2009. Given the significant changes in various aspects of the global financial markets, this edition is a substantial revision of the fourth edition. The table on pages xix–xxi compares the fourth edition to this new edition. The overriding emphasis when revising the book was to make it more global centric—hence the addition of the word “Global” in the book’s new title. Consequently, the U.S. financial market is still covered in considerable detail, but we describe non-U.S. financial markets as well. For practical reasons, it is not possible for us to include a detailed discussion of every country’s financial market. Instead, we show how the financial markets of other countries may be similar to or differ significantly from that of the U.S. market. Frank J. Fabozzi Frank J. Jones Acknowledgments We benefited greatly from the assistance of several individuals. Steven Mann and Francesco Fabozzi made major contributions. Steven Mann coauthored two chapters. Francesco Fabozzi provided research for several chapters, coauthored chapter 12, and prepared the end-of-chapter questions for more than half of the chapters. For this reason, they are given special recognition on the title page and book’s cover. Discussions with the following individuals were helpful in preparing some of the chapters: Michele-Leonardo Bianchi, Jeff Buetow, Jack Francis, Andy Jones, Andrew Kalotay, Jang Ho Kim, Woo Chang Kim, Svetlozar Rachev, and Stoyan Stoyanov. Many chapters in the fifth edition were read by students who provided feedback that we found useful when revising some of the chapters. These students are Trey Aslanian (Princeton University), Matt Scarpill (St. Joseph’s University), Aidan Young (University of Pennsylvania), and Desmond Young (University of Pennsylvania). We are grateful to Professor Robert Shiller of Yale University, who has been supportive of all editions of this book. His endorsement of prior editions of this book is in his courseware video (Open Yale Course: https:// oyc.yale.edu/economics/econ-252-08). We also acknowledge some individuals who have helped us in numerous respects in the prior four editions of the book; they do not bear the burden of any errors or mistakes that may appear in the text. The following people, listed in alphabetical order, read some parts of the material that has gone into one of the editions of this text: Robert Arnott, Paul Asquith, Anand Bhattacharya, Helen M. Bowers, John H. Carlson, Bruce Collins, John Crockett, Henry Gabbay, Gary L. Gastineau, Gerald Hanweck, Arthur Hogan, Jane Howe, David P. Jacob, Frank Keane, Robert Kieschnick, Martin Leibowitz, K. C. Ma, Inayat U. Mangla, Ed Murphy, Mark Pitts, Richard Puntillo, Scott Richard, Manijeh Sabi, Dexter Senft, Richard Wilson, Eleanor Xu, Uzi Yaari, and Jot Yau. Finally, Frank Fabozzi is grateful to his wife Donna for sacrificing social time to allow him to complete this three-year project and for her encouragement. Frank Jones is grateful to his wife Sally, whose limitless support was indispensable. Overview of the Book The emphasis on topic coverage is best explained by providing an overview of the book and how the current edition differs from the previous edition (the fourth edition). The book is divided into eight parts. Every chapter concludes with key points that are in bullet format so that the student can quickly review the concepts and principles covered in the chapter. Part I: Financial Markets and Players In this nine-chapter part, chapter 1 provides an introduction to financial markets, the attributes of financial assets, and the link between financial markets and the real economy. Chapter 2 (a new chapter) explains the role of governments in financial markets. Trying to understand the attributes of financial instruments without a thorough understanding of those who participate (the “players”) in the financial market makes little sense. Understanding why private market participants actively buy certain types of financial instruments and avoid other types requires becoming familiar with the investment objectives of a wide range of investor types, as well as with any regulatory constraints that might be imposed. Chapter 3 covers the special role of financial entities called “financial intermediaries” and asset management firms. In chapter 4 (a new chapter), we provide an overview of private market participants. A key player in the financial market that we believe deserves its own chapter is the credit rating agencies, the subject of chapter 5 (a new chapter). Chapter 6 focuses on depository institutions, followed in chapter 7 (a new chapter) by the role of central banks. Insurance companies and the wide range of activities of investment banking firms are the subjects of chapters 8 and 9, respectively. Part II: Understanding Risks and Asset Pricing The five chapters in part II cover the risks that investors and issuers are exposed to when participating in financial markets and the implications for the pricing of assets. One of the objectives in the study of finance is to understand the trade-off between risk and return. The term “risk” carries many meanings in finance, depending on the context in which it is used. Rather than leave the concept of risk vague and describe its meaning in different contexts as they arise throughout the book, in chapter 10—a new chapter to this edition of the book—we provide an overview of risk. The chapter covers the difference between risk and uncertainty, the key elements of financial risk management and the identification of financial risks, the various types of investment risk faced by investors, and the various types of funding risk faced by entities seeking to raise capital. The major topics in the balance of part II cover the properties and general principles in the pricing of financial assets (chapter 11), asset return distributions and the quantification of some risk measures (chapter 12), the selection of assets to include in a portfolio (chapter 13, a new chapter), and the theory of how assets are priced (chapter 14). These are the major theories in finance, and there is considerable debate as to whether these theories correctly describe the way investors should construct an investment portfolio (i.e., portfolio theory) and how assets should be priced (i.e., asset pricing theory). Chapter 12, which describes return distributions and risk measures, is a new chapter to this book. The four principal topics covered in the chapter are the different types of distributions that financial asset returns can follow, different measures of dependence between asset returns, attributes of portfolio risk measures, and alternative ratios of reward to risk. This chapter precedes the chapters on portfolio theory and asset pricing, because the material presented is necessary to understand those theories and (just as important) the limitations of those theories. Although the topics draw on basic concepts in statistics, the coverage is at an elementary level. There are three important takeaways from chapter 12. The first is that substantial empirical evidence from real-world markets indicates that return distributions for financial assets do not follow the normal distribution, as assumed in much of finance theory. In fact, some market commentators believe that the failure of many financial models reported during the Great Recession of 2008–2009 is the result of relying on the assumption that returns follow a normal distribution, the principal distribution covered in introductory probability and statistics courses. The second takeaway is that a measure of dependence between financial asset returns as assumed in traditional portfolio theory, the covariance or correlation, is just one measure of dependence. For the purpose of both portfolio management and risk management, better measures can be employed. Finally, the measure of portfolio risk used in traditional finance theory is the variance or standard deviation. Other measures that offer a better means for capturing risk are available, and these measures affect the reward/risk ratios that should be used by investors when constructing portfolios. Part III: Interest Rates, Interest Rate Risk, and Credit Risk The structure of interest rates and interest rate and credit risks are the subjects of part III. Chapter 15, the first of two chapters in part III, focuses on the classical theory of interest rates, which, it is assumed, provides the anchor for all interest rates in an economy. The classical theory of interest rates provides insight into what factors determine the level of interest rates in an economy. However, there is not a single interest rate. Rather there is a structure of interest rates. In chapter 16, we look closely at the structure of interest rates. We will see that there are a myriad of factors influencing the interest rates that investors seek on alternative investment products. These factors include the type of issuer, the characteristics of the debt obligation, and the state of the economy. The concepts introduced at the beginning of chapter 16 are used to demonstrate how debt obligations should be priced in the market, as well as how to determine the calculation of a bond’s yield. In the last section of chapter 16, we explain the relationship between the yield on a debt instrument and its maturity, which is referred to as the “term structure of interest rates.” The different economic theories that have been offered to explain the term structure of interest rates are described. Part IV: Primary and Secondary Markets The three chapters in part IV first cover the fundamentals of primary markets (chapter 17) and secondary markets (chapter 18). The characteristics of these markets and their regulation are covered in these two chapters. The chapters begin by discussing regulations in the U.S. market and then move on to regulation in other developed countries. The last of the three chapters, chapter 19, covers the foreign exchange market. Chapter 19 is a new chapter in the book. In the previous edition, this topic was covered in the chapter on foreign exchange derivatives. Part V: Global Government Debt Markets In the previous edition of the book, two chapters covered the government debt market: one on the U.S. Treasury market and the other on the municipal securities market. In this edition, the U.S. Treasury market is covered in chapter 20, but that chapter has been expanded to include non-U.S. sovereign debt markets. The U.S. municipal securities market is described in chapter 21. That chapter also covers subnational government debt markets and the importance of the development of that market for infrastructure financing in both developed and developing markets. Given the substantial expansion of the coverage in these chapters, they are basically new chapters. Part VI: Corporate Funding Markets The seven chapters covered in part VI describe the various financial markets that corporations and other business entities use to obtain funding. The first three chapters (chapters 22, 23, and 24) focus on equity markets. Chapter 22 describes the structure and trading venues of the U.S. equity market, and chapter 23 covers strategies that are used by investors in this market and the important topic of pricing efficiency. Non-U.S. equity markets, with emphasis on the relatively new and large Chinese market, are covered in chapter 24, a new addition to the book. The debt markets available to corporation and other business entities are covered in chapters 25–28. The global short-term funding market (more popularly referred to as the “global money market”) is the subject of chapter 25; the intermediate- to long-term corporate notes and bonds are the subject of chapter 26.  Securitization is a tool for the creation of a corporate debt instrument backed by a pool of corporate-related assets, such as receivables and future revenue. Often one thinks of securitization being used for the creation of mortgage-backed securities that we discuss in the next part of the book. However, corporations use securitization for a variety of reasons, such as reducing funding costs and managing risk. The securitization process and the parties to a securitization are described in chapter 27. A new addition to the book is the financial market for small and medium- sized enterprises and new entrepreneurial ventures, with emphasis on start- ups and venture capital. This coverage is in chapter 28, where the various types of financial instruments available to such entities—as well as the regulations pertaining to the issuance of those financial instruments—are discussed. Part VII: Real Estate Markets Real estate can be classified as either residential properties or commercial properties. Residential real estate includes one- to four-family properties. Chapter 29 describes the residential mortgage market where homeowners obtain funding to purchase a home and the types of mortgage loans. The pooling of residential mortgage loans to create a residential mortgage-backed security is the subject of chapter 30. In that chapter, agency residential mortgage-backed securities and residential private-label mortgage-backed securities are described. Also described in that chapter are mortgage derivative securities: collateralized mortgage obligations and stripped mortgage-backed securities. Commercial real estate is income-producing properties and is the subject of chapter 31. The major commercial property types are multifamily housing, apartment buildings, office buildings, industrial properties (including warehouses), shopping centers, hotels, health care facilities (e.g., senior housing care facilities), and timberlands. Commercial real estate investments are classified as follows: private commercial real estate equity, public commercial real estate equity, private commercial real estate debt, and public commercial real estate debt. Each type is described in the chapter. Part VIII: Collective Investment Vehicles and Financial Derivatives Markets This last part of the book has eight chapters and begins with a description of collective investment vehicles (chapter 32), which is a new addition to the book. Collective investment vehicles are products that are managed by asset management firms. These investment vehicles involve the pooling of funds by asset management firms and the investment of those funds in certain financial assets. The major collective investment vehicles covered in this chapter are investment company shares (i.e., mutual funds/open-end funds and closed- end funds), exchange-traded funds, hedge funds, real estate investment trusts, and venture capital funds. The seven remaining chapters focus on various types of financial derivatives, or simply, “derivatives.” Chapters 33 and 34 describe financial futures and options, respectively. The pricing and applications of futures and options are the subjects of chapters 35 and 36, respectively. The various types of interest rate derivatives traded in the over-the-counter market (forward rate agreements, interest rate swaps, caps, and floors) are described in chapter 37. Foreign-exchange derivative markets are covered in chapter 38, and the market for credit risk transfer vehicles (the most important being credit default swaps) is the subject of the last chapter in the book, chapter 39. Fifth Edition versus Fourth Edition Comments Part I: Financial Markets and Players 1 Introduction Modified from chapter 1 to reflect the new structure of the book 2 Role of Governments in Financial Markets New chapter 3 Financial Institutions, Financial Update of chapter 2 Intermediaries, and Asset Management Firms 4 Overview of Private Market Participants New chapter 5 Credit Rating Agencies and Their Role in New chapter Financial Markets 6 Depository Institutions: Activities and Update of chapter 3 Characteristics 7 Central Banks New chapter 8 Insurance Companies Update of chapter 6 9 Investment Banking Firms Modification of chapter 7 Part II: Understanding Risks and Asset Pricing 10 Overview of Risks and Their Management New chapter 11 Properties and Pricing of Financial Assets Chapter 9 in 4th edition 12 Return Distributions, Risk Measures, and New chapter Risk-Return Ratios 13 Portfolio Selection Theory New chapter 14 Asset Pricing Theories Revised chapter 12 Part III: Interest Rates, Interest Rate Risk, and Credit Risk 15 The Theory of Interest Rates Revised chapter 10 16 The Structure of Interest Rates Revised chapter 11 Part IV: Primary and Secondary Markets 17 Primary Markets Revised chapter 13 18 Secondary Markets Revised chapter 14 19 The Foreign Exchange Market New chapter Part V: Global Government Debt Markets 20 Sovereign Debt Markets New chapter 21 Subnational (Municipal) Government Debt New chapter Markets Part VI: Corporate Funding Markets 22 The Structure and Trading Venues of the Revised chapters 17 and 18 Equity Market 23 U.S. Common Stock Market: Pricing Revised chapters 17 and 18 Efficiency, Trading, and Investment Strategies 24 Non-U.S. Equity Markets New chapter 25 Global Short-Term Funding and Investing New chapter Markets 26 Corporate Debt Markets Revised chapters 19 and 20 27 Market for Asset-Backed Securities Revised chapter 25 28 Financing Market for Small, Medium-Sized, New chapter and Entrepreneurial Enterprises Part VII: Real Estate Markets 29 The Residential Mortgage Market Updated chapter 22 30 Residential Mortgage-Backed Securities Updated chapter 23 Market 31 Commercial Real Estate Markets New chapter Part VIII: Collective Investment Vehicles and Financial Derivatives Markets 32 Market for Collective Investment Vehicles New chapter 33 Financial Futures Markets Chapter 26 in 4th edition 34 Options Markets Chapter 27 in 4th edition 35 Pricing Futures and Options Contracts Chapter 28 in 4th edition 36 Applications of Futures and Options Chapter 29 in 4th edition Contracts 37 Over-the-Counter Interest Rate Derivatives: Chapter 30 in 4th edition Forward Rate Agreements, Swaps, Caps, and Floors 38 Market for Foreign Exchange Derivatives Revised chapter 31 39 Market for Credit Risk Transfer Vehicles Chapter 32 in 4th edition I FINANCIAL MARKETS AND PLAYERS 1 Introduction CONTENTS Learning Objectives Financial Assets Debt versus Equity Instruments The Price of a Financial Asset and Risk Financial Assets versus Tangible Assets The Role of Financial Assets Financial Markets The Role of Financial Markets Classification of Financial Markets Market Participants Globalization of Financial Markets Classification of Global Financial Markets Developed, Emerging, and Frontier Markets Asset Classes Derivatives Markets Types of Derivative Instruments The Role of Derivative Instruments Financial Markets and the Real Economy Key Points Questions Learning Objectives After reading this chapter, you will understand:  the components of the financial system; what a financial asset is and the principal economic functions of financial assets; the distinction between financial assets and tangible assets; what a financial market is and the principal economic functions it performs; the distinction between debt instruments and equity instruments; the various ways to classify financial markets; the differences between the primary and secondary markets; who participates in financial markets; the reasons for the globalization of financial markets; the distinction between an internal market and an external market; the distinction between a domestic market, a foreign market, and the Euromarket; the reasons entities use foreign markets and the Euromarkets; the differences among developed, emerging, and frontier stock markets; what is meant by an asset class; what a derivative instrument is and the two basic types of derivative instruments; the role of derivative instruments; and the link between financial markets and the real economy. In a market economy, the allocation of economic resources is the outcome of many private decisions. Prices are the signals operating in a market economy that direct economic resources to their best use. The types of markets in an economy can be divided into (1) the markets for products (manufactured goods and services), called the product markets, and (2) the market for the factors of production (labor and capital), called the factor markets. Our purpose in this book is to focus on one part of the factor markets, the market for financial assets, or more simply, the financial market. The financial market is one of the three major components of the financial system. The other two components are financial institutions and financial market infrastructure. Financial institutions are the entities that provide financial services to other entities in the financial system. They include depository institutions (e.g., banks), insurance companies, and securities firms. Financial market infrastructure is the component of the financial system that involves processing the payments of financial assets. In this chapter, we will look at the role of financial markets, the “things” that are traded (i.e., bought and sold) in financial markets, the reasons for the integration of world financial markets, and the government’s role in the regulation of these markets. Chapters that follow deal with the key financial institutions, and the financial market infrastructure will be discussed when we describe the different sectors of the financial market. Financial Assets We begin with a few basic definitions. An asset, broadly speaking, is any possession that has value in an exchange. Assets can be classified as tangible or intangible. A tangible asset is one whose value depends on particular physical properties—examples are buildings, land, or machinery. Intangible assets, by contrast, represent legal claims to some future benefit. Their value bears no relation to the form, physical or otherwise, in which these claims are recorded. Financial assets are intangible assets. For financial assets, the typical benefit or value is a claim to future cash. With one exception (real estate, which is a tangible asset), this book deals with the various types of financial assets, the markets where they are traded, and the principles for valuing them. Throughout this book, we use the terms “financial asset,” financial instrument, and security interchangeably. The entity that has agreed to make future cash payments is called the issuer of the financial asset; the owner of the financial asset is referred to as the investor. Here are just seven examples of financial assets: a loan by Bank of America (investor) to an individual (issuer/borrower) to purchase a car a bond issued by the U.S. Department of the Treasury a bond issued by AT&T  a bond issued by the City of New York a bond issued by the German government a share of common stock issued by Apple Inc. a share of common stock issued by Honda Motor Company, a Japanese automotive company In the case of the car loan, the terms of the loan establish that over time, the borrower must make specified payments to the Bank of America. The payments include repayment of the amount borrowed plus interest. The cash flow for this asset is made up of the specified payments that the borrower must make. In the case of a U.S. Treasury bond, the U.S. government (the issuer) agrees to pay the investor the bond interest payments every six months until the bond matures, and then at the maturity date, repay the amount borrowed. The same is true for the bonds issued by AT&T, the City of New York, and the German government. In the case of AT&T, the issuer is a corporation, not a government entity. In the case of the City of New York, the issuer is a municipal government. The issuer of the German government bond is a central government entity. The common stock of Apple Inc. entitles the investor to receive dividends distributed by the company. In this case, the investor also has a claim to a pro rata share of the net asset value of the company in the case of the company’s liquidation in a bankruptcy. The same is true of the common stock of Honda Motor Company. Debt versus Equity Instruments The claim that the holder of a financial asset has may be either a fixed amount or a varying, or residual, amount. In the former case, the financial asset is referred to as a debt instrument. The car loan, the U.S. Treasury bond, the AT&T bond, the City of New York bond, and the German government bond cited above are examples of debt instruments requiring fixed payments. An equity instrument (also called a residual claim) obligates the issuer of the financial asset to pay the holder an amount based on earnings, if approved by the board of directors, after holders of debt instruments have been paid. Common stock is an example of an equity instrument. A partnership share in a business is another example. Some securities fall into both categories. For example, preferred stock is an equity instrument, issued in the United States but not all countries, which entitles the investor to receive a fixed amount. This payment is contingent, however, and due only after payments to debt instrument holders are made. Another “combination” instrument is a convertible bond, which allows the investor to convert debt into equity under certain circumstances. Both debt and preferred stock are called fixed-income instruments. Certain types of financial instruments may seem odd at first. For example, there are bonds issued by life insurance companies where payments are made based on mortality rates or bonds issued by a mining company where the payments are based on the price of the natural resource being mined. Once you understand the needs of issuers and the risk/return relationships in financial markets to compensate investors for taking on certain risks, what may at first appear to be an odd or unusual financial instrument will make economic sense. Indeed, the purpose of this book is to help you understand the global financial markets and the players in the markets, so that you can understand why every type of financial instrument traded in the market fulfills the needs of issuers, investors, or both. The Price of a Financial Asset and Risk A basic economic principle is that the price of any financial asset is equal to the present value of its expected cash flow, even if the cash flow is not known with certainty. By cash flow, we mean the stream of cash payments over time. For example, if a U.S. government bond promises to pay $20 every six months for the next 30 years and $1,000 at the end of 30 years, then this is the bond’s cash flow. In the case of the car loan by Bank of America, if the borrower is obligated to pay $500 every month for three years, then this is the cash flow of the loan. We elaborate on this principle throughout this book as we discuss several theories for the pricing of financial assets.  Directly related to the notion of price is the expected return on a financial asset. Given the expected cash flow of a financial asset and its price, we can determine its expected rate of return. For example, if the price of a financial asset is $100, and its only cash flow is $105 one year from now, then its expected return would be 5%. The type of financial asset, whether debt instrument or equity instrument, as well as the characteristics of the issuer, determine the degree of certainty of the expected cash flow. For example, assuming that the U.S. government is not expected to default on the debt instruments it issues, the cash flow of U.S. Treasury securities is known with certainty. What is uncertain, however, is the purchasing power of the cash flow received. In the case of the Bank of America car loan, the ability of the borrower to repay presents some uncertainty about the cash flow. But, if the borrower does not default on the loan obligation, the investor (Bank of America) knows what the cash flow will be. The same is true for the bonds of AT&T and the City of New York. In the case of the German government bond, the cash flow is known if the government of Germany does not default. However, the cash flow may be denominated not in U.S. dollars but in the German currency, the euro. Thus, although the cash flow is known in terms of the number of euros that will be received, from the perspective of a U.S. investor, the number of U.S. dollars is unknown. The number of U.S. dollars will depend on the exchange rate between the euro and the U.S. dollar at the time the cash flow is received. The holder of Apple common stock is uncertain as to both the amount and the timing of dividend payments. Dividend payments will be related to company profits. The same is true for the cash flow of the common stock of Honda Motor Company. In addition, because Honda will make dividend payments in Japanese yen, there is uncertainty about the cash flow in terms of U.S. dollars. We explain various types of risk in chapter 10, as well as in other chapters throughout this book, but we can see three of these risks in our examples in this chapter. The first is the risk attached to the potential purchasing power of the expected cash flow. This is called purchasing power risk or inflation risk. The second is the risk that the issuer or borrower will default on the obligation. This is called credit risk, or more specifically, as explained in chapter 10, default risk. Finally, for financial assets whose cash flow is not denominated in U.S. dollars, there is the risk that the exchange rate will change adversely, resulting in fewer U.S. dollars. This risk is referred to as foreign-exchange risk or currency risk. Financial Assets versus Tangible Assets A tangible asset, such as plant or equipment purchased by a business entity, shares at least one characteristic with a financial asset: Both are expected to generate future cash flow for their owner. For example, suppose a U.S. airline purchases a fleet of aircraft for $500 million. With its purchase of the aircraft, the airline expects to realize cash flow from passenger travel. Financial assets and tangible assets are linked. Ownership of tangible assets is financed by the issuance of some type of financial asset—either debt instruments or equity instruments. For example, in the case of the airline, suppose that a debt instrument is issued to raise the $500 million to purchase the fleet of aircraft. The cash flow from passenger travel will be used to service the payments on the debt instrument. Ultimately, therefore, the cash flow for a financial asset is generated by some tangible asset. The Role of Financial Assets Financial assets have two principal economic functions. The first is to transfer funds from those who have surplus funds to invest to those who need funds to invest in tangible assets. The second economic function is to transfer funds in such a way as to redistribute the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds. However, as we will see, the claims held by the final wealth holders are generally different from the liabilities issued by the final demanders of funds because of the activity of financial intermediaries that seek to transform the final liabilities into the financial assets that the public prefers. We can illustrate these two economic functions with three examples:  1. Richie Calbo has obtained a license to manufacture wristwatches with the logo for the U.S. Navy. He estimates that he will need $1.2 million to purchase plant and equipment to manufacture the watches. Unfortunately, he has only $300,000 to invest, and that is his life savings, which he does not want to invest, even though he has confidence that there will be a receptive market for the watches. 2. Amanda Santigo, an entrepreneur, has recently invented a product for the inexpensive and rapid processing of DNA samples for forensic science labs and has sold the rights for an amount that netted her $1 million after taxes. She plans to spend $150,000 to purchase a condominium, $50,000 on a car, and to invest the balance, $800,000. 3. Hasan Rahman, an associate at a major Los Angeles law firm, has received a bonus check that after taxes has netted him $280,000. He plans to spend $80,000 on a BMW and invest the balance, $200,000. Suppose that, quite by accident, Richie, Amanda, and Hasan meet at a social function. Sometime during their conversation, they discuss their financial plans. By the end of the evening, they agree to a deal. Richie agrees to invest $200,000 of his savings in the business and raise the balance of the $1 million needed to purchase the plant and equipment as follows. Amanda agrees to buy a 50% interest for $800,000. Hasan agrees to lend Richie $200,000 for four years at an interest rate of 12% per year. Richie will be responsible for operating the business without the assistance of Amanda or Hasan. Two financial claims came out of this meeting and the transactions that the parties agree to. The first is an equity instrument issued by Richie and purchased by Amanda for $800,000. The other is a debt instrument issued by Richie and purchased by Hasan for $200,000. Thus, the two financial assets allowed funds to be transferred from Amanda and Hasan, who had surplus funds to invest, to Richie, who needed funds to invest in tangible assets to manufacture the watches. This transfer of funds is the first economic function of financial assets. That Richie is not willing to invest his life savings of $300,000 means that he wanted to transfer part of that risk. He does so by selling Amanda a financial asset that gives her a financial claim equal to one-half the cash flow from the business. He secures an additional amount of capital from Hasan, who is not willing to share in the risk of the business (except for credit risk), in the form of an obligation requiring payment of a fixed cash flow, regardless of the outcome of the venture. This shifting of risk is the second economic function of financial assets. Financial Markets A financial market is a market where financial assets are exchanged (i.e., traded). Although the existence of a financial market is not a necessary condition for the creation and exchange of a financial asset, in most economies, financial assets are created and subsequently traded in some type of financial market. The market in which a financial asset trades for immediate delivery is called the spot market or cash market. The Role of Financial Markets We previously explained the two primary economic functions of financial assets. Financial markets provide three additional economic functions. First, the interactions of buyers and sellers in a financial market determine the price of the traded asset. Or, equivalently, they determine the required return on a financial asset. Because the inducement for firms to acquire funds depends on the required return that investors demand, it is this feature of financial markets that signals how the funds in the economy should be allocated among financial assets. This is called the price discovery process. Second, financial markets provide a mechanism for an investor to sell a financial asset. Because of this ability, it is said that a financial market offers liquidity, an attractive feature when circumstances either force or motivate an investor to sell a financial asset. In the absence of liquidity, the owner would be forced to hold a debt instrument until it matures and an equity instrument until the company is either voluntarily or involuntarily liquidated. Although all financial markets provide some form of liquidity, the degree of liquidity is one of the factors that characterize different markets.  The third economic function of a financial market is that it reduces the cost of transacting. There are two costs associated with transacting: search costs and information costs. Search costs represent explicit costs, such as the money spent to advertise one’s intention to sell or purchase a financial asset, and implicit costs, such as the value of time spent locating a counterparty. The presence of some form of organized financial market reduces search costs. Information costs are costs associated with assessing the investment merits of a financial asset, that is, the amount and the likelihood of the cash flow expected to be generated. In a price efficient market, prices reflect the aggregate information collected by all market participants. Classification of Financial Markets Financial markets can be classified in many ways. One way is by the type of financial claim, such as debt markets and equity markets. Another is by the maturity of the claim. For example, there is a financial market for short-term debt instruments, called the money market, and one for longer-maturity financial assets, called the capital market. Financial markets can be categorized as those dealing with financial claims that are newly issued, called the primary market, and those for exchanging financial claims previously issued, called the secondary market or the market for seasoned instruments. Markets are classified as either cash instrument markets or derivative instruments markets. (The latter is described briefly later in this chapter and in more detail in chapter 39.) A market can be classified by its organizational structure: It may be an auction market, an over-the-counter market, or an intermediated market. All these classifications are summarized in table 1.1. Table 1.1 Summary of classification of financial markets. Classification by nature of claim: Debt market Equity market Classification by maturity of claim: Money market Capital market Classification by seasoning of claim: Primary market Secondary market Classification by immediate delivery or future delivery: Cash (spot) market Derivatives market Classification by organizational structure: Auction market Over-the-counter market Intermediated market Market Participants Participants in the global financial markets that issue and purchase financial claims include households, business entities (corporations and partnerships), national governments, national government agencies, state and local governments, and supranationals (such as the World Bank, the European Investment Bank, and the Asian Development Bank). Business entities include nonfinancial and financial enterprises. Nonfinancial enterprises manufacture products (for example, cars, steel, and computers), provide nonfinancial services (including transportation, utilities, and computer programming), or do both. The roles in financial markets played by financial enterprises and a special type of financial enterprise known as a financial intermediary are described in chapter 2. Finally, although we have focused on market participants that create and/or exchange financial assets, a broader definition of market participants would include regulators of financial markets. Globalization of Financial Markets Because of the globalization of financial markets, entities in any country seeking to raise funds need not be limited to their domestic financial market. Nor are investors in a country limited to the financial assets issued in their domestic market. Globalization means the integration of financial markets throughout the world into an international financial market. The factors that have led to the integration of financial markets are (1) deregulation or liberalization of markets and the activities of market participants in key financial centers of the world; (2) technological advances for monitoring world markets, executing orders, and analyzing financial opportunities; and (3) increased institutionalization of financial markets. Global competition has forced governments to deregulate (or liberalize) various aspects of their financial markets so that their financial enterprises can compete effectively around the world. Technological advances have increased the integration and efficiency of the global financial market. Advances in telecommunication systems have linked market participants throughout the world, with the result that orders can be executed within milliseconds. Advances in computer technology, coupled with advanced telecommunication systems, allow the transmission of real-time information on security prices and other key information to many participants in many places. Therefore, many investors can monitor global financial markets and simultaneously assess how this information will impact the risk/return profile of their portfolios. Significantly improved computing power allows the instant manipulation of real-time market information, so that arbitrage opportunities can be identified. Once these opportunities are identified, telecommunication systems permit the rapid execution of orders to capture them. The U.S. financial markets have shifted from domination by retail investors to domination by financial institutions. By retail investors we mean individuals. For example, when you or I buy a share of common stock, we are referred to as retail investors. Examples of financial institutions are pension funds, insurance companies, mutual funds, commercial banks, and savings and loan associations. We describe these financial institutions in the next eight chapters. Throughout this book, we will refer to these financial institutions as institutional investors. The shifting of the financial markets from dominance by retail investors to institutional investors is referred to as the institutionalization of financial markets. The same thing is occurring in other industrialized countries. Unlike retail investors, institutional investors have been more willing to transfer funds across national borders to improve portfolio diversification or exploit perceived mispricing of financial assets in foreign countries. The potential portfolio diversification benefits associated with global investing have been documented in numerous studies, which have heightened the awareness of investors about the virtues of global investing. Classification of Global Financial Markets Although there is no uniform system for classifying the global financial markets, an appropriate schematic presentation appears in figure 1.1. From the perspective of a given country, financial markets can be classified as either internal or external. The internal market, also referred to as the national market, is composed of two parts: the domestic market and the foreign market. The domestic market in a country is where issuers domiciled in that country issue securities and where those securities are subsequently traded. Figure 1.1 Classification of global financial markets. The foreign market of any country is where the securities of issuers not domiciled in the country are sold and traded. The rules governing the issuance of foreign securities are those imposed by regulatory authorities where the security is issued. For example, securities issued by foreign corporations in the United States must comply with the regulations set forth in U.S. securities law. A non-Japanese corporation that seeks to offer securities in Japan must comply with Japanese securities law and regulations imposed by the Japanese Ministry of Finance.  Nicknames have developed to describe the various foreign markets. For example, the foreign market in the United States is called the “Yankee market.” The foreign market in Japan is nicknamed the “Samurai market”; in the United Kingdom, the “Bulldog market”; in the Netherlands, the “Rembrandt market”; and in Spain, the “Matador market.” The external market, also referred to as the international market, allows trading of securities with two distinguishing features: (1) at issuance, securities are offered simultaneously to investors in various countries; and (2) they are issued outside the jurisdiction of any single country. The external market is commonly referred to as the offshore market, or, more popularly, the Euromarket.1 Developed, Emerging, and Frontier Markets Countries and their equity markets are typically divided into three categories: developed, emerging (developing), and frontier (pre-emerging). The differences among these three types are based mainly on two factors: the development of their economies and of their capital markets.2 Their economic development refers mainly to their per capita income and potential growth. Developed countries have higher levels of per capita income but lower potential growth. The development of their capital markets refers to the size of their market capitalization (described next), the level of liquidity, and the development of their supporting regulatory and legal bodies. These two characteristics affect the growth potential, risk, and liquidity of investments in their markets. Developed countries are found mostly in North America, Western Europe, and Australasia, including the United States, Canada, Germany, the United Kingdom, Australia, New Zealand, and Japan. An emerging (developing) market is a country that has some of the characteristics of a developed market but not all of them. Developing countries include Brazil, Russia, India, and China (as a group, popularly referred to as BRIC); Portugal, Ireland, Italy, Greece, Spain (PIIGS); and other countries. A frontier or pre-emerging market is a market that is too small and undeveloped to be considered an emerging market. Asset Classes In financial markets, participants talk about asset classes. In the financial markets of most developed countries, the asset classes are (1) common stocks, (2) bonds, (3) cash equivalents, and (4) real estate. How do market participants define their asset classes? There are two ways they do so. One way is in terms of the investment attributes that the members of the asset class have in common. These investment characteristics include the major economic factors that affect the value of the asset class, and as a result, correlate highly with the returns of each member of the asset class, have similar risk and return characteristics, and have a common legal or regulatory structure. Hence, based on this way of defining asset classes, the correlation between the returns of different asset classes would be low. Another way of defining an asset class is based simply on the characteristics of a group of assets that is treated as an asset class by asset managers. Based on these two ways of defining asset classes, the traditional asset classes above can be extended to generate other such classes. From the perspective of a U.S. investor, for example, the traditional asset classes listed above have been expanded by separating foreign stocks and bonds into those issued by U.S. entities and those issued by foreign entities. Moreover, common stocks and bonds are further divided into more asset classes based on the size of the corporation. Here, size refers to the market capitalization of the corporation’s common stock. A corporation’s market capitalization (or simply, “market cap”) is equal to the total market value of its common stock outstanding. For example, suppose that a corporation has 50 million shares of common stock outstanding, and each share has a market value of $400. Then this corporation’s market cap is $20 billion (50 million shares × $400 per share).3 In the United States, one way of classifying asset classes is based on market cap: mega-cap stocks (greater than $200 billion), large-cap stocks ($10 billion to $200 billion), mid-cap stocks ($1 billion to $10 billion), small-cap stocks ($300 million to $1 billion), micro-cap stocks ($50 million to $300 million), and  nano-cap stocks (less than $50 million). Except for real estate, all the asset classes identified above are referred to as traditional asset classes. Real estate and all other asset classes that are not in the above list are referred to as nontraditional asset classes or alternative asset classes. They include commodities, private equities, hedge funds, venture capital, real assets, and currencies. Derivatives Markets So far, we have focused on the cash market for financial assets. With some contracts, the contract holder has either the obligation or the choice to buy or sell a financial asset at some future time. The price of any such contract derives its value from that of the underlying financial asset, financial index, or interest rate. Consequently, these contracts are called derivative instruments. Types of Derivative Instruments The two basic types of derivative instruments are futures/forward contracts and options contracts. A futures or forward contract is an agreement whereby two parties agree to transact with respect to some financial asset at a predetermined price at a specified future date. One party agrees to buy the financial asset; the other agrees to sell the financial asset. Both parties are obligated to perform, and neither party charges a fee. The distinction between a futures and a forward contract and why this type of derivative is referred to as a risk-sharing type of derivative are explained in chapter 33. An options contract gives the owner of the contract the right, but not the obligation, to buy (or sell) a financial asset at a specified price from (or to) another party. The buyer of the contract must pay the seller a fee, which is known as the option price. When the option grants the owner of the option the right to buy a financial asset from the other party, the option is a call option. If, instead, the option grants the owner of the option the right to sell a financial asset to the other party, the option is a put option. Options are more fully explained in chapter 34.  Derivative instruments are not limited to financial assets. Some derivative instruments involve commodities and precious metals. Our focus in this book, however, is on derivative instruments whose underlying asset is a financial asset or some financial benchmark, such as a stock index or an interest rate, a credit spread, or foreign exchange. Moreover, other types of derivative instruments are basically packages of either forward contracts or option contracts. These include swaps, caps, and floors, all of which are discussed in chapter 37. The Role of Derivative Instruments Derivative instruments provide issuers and investors with an inexpensive way of controlling some major risks. While we describe most of these risks in chapter 10, here are three examples that clearly illustrate the need for derivative instruments: 1. Suppose that AT&T plans to obtain a bank loan for $700 million two months from now. The key risk here is that two months from now, the interest rate will be higher than it is today. Even if the interest rate were only one percentage point higher, AT&T would have to pay $7 million more in annual interest. Clearly, then, issuers and borrowers want a way to protect against a rise in interest rates. 2. IBM’s defined benefit pension fund owns a portfolio consisting of the common stock of a large number of companies. (We describe defined benefit pension funds in chapter 4, but for now, the only salient point is that this type of pension fund must make periodic payments to the beneficiaries of the plan.) Suppose the pension fund managers know that two months from now, they must sell stock in its portfolio to pay beneficiaries $20 million. The risk that the IBM pension fund faces is that two months from now when the stocks are sold, the price of most or all stocks may be lower than they are today. If stock prices do decline, the pension fund will have to sell off more shares to realize $20 million. Thus, investors, such as the IBM pension fund managers, face the risk of declining stock prices and may want to protect against this risk.  3. Suppose Coca-Cola Company plans to issue a bond in Switzerland and the periodic payments that the company must make to the bondholders are denominated in the Swiss currency, the franc. The amount in U.S. dollars that Coca-Cola must pay to receive the amount in Swiss francs it has contracted to pay will depend on the exchange rate at the time the payment must be made. For example, suppose that at the time Coca-Cola plans to issue the bonds, the exchange rate is such that 1 U.S. dollar is equal to 1.5 Swiss francs. So, for each 7.5 million Swiss francs that Coca-Cola must pay to the bondholders, it must pay U.S. $5 million. If at any time that a payment must be made in Swiss francs, the value of the U.S. dollar declines relative to the Swiss franc, Coca-Cola will have to pay more U.S. dollars to satisfy its contractual obligation. For example, if 1 U.S. dollar at the time of a payment changes to 1.25 Swiss francs, Coca-Cola would have to pay $6 million to make a payment of 7.5 million Swiss francs. This is U.S. $1 million more than when it issued the bonds. Issuers and borrowers who raise funds in a currency that is not their local currency face this currency risk. The derivative instruments described in part VIII of this book can be used by the two borrowers (AT&T and Coca-Cola) and the one investor (IBM’s defined benefit pension fund) in these examples to eliminate or to reduce the kinds of risks that they face. As we will see in later chapters, derivatives markets may have at least three advantages over the corresponding cash (spot) market for the same financial asset. First, depending on the derivative instrument, it may cost less to execute a transaction in the derivatives market to adjust the risk exposure to new economic information than it would cost to make that adjustment in the cash market. Second, transactions typically can be accomplished faster in the derivatives market than in the cash one. Third, some derivatives markets can absorb a greater dollar transaction without an adverse effect on the price of the derivative instrument; that is, the derivatives market may be more liquid than the cash market. The key point here is that derivative instruments play a critical role in global financial markets. A May 1994 report published by the U.S. Government Accountability Office (GAO) titled Financial Derivatives: Actions Needed to Protect the Financial System recognized the importance of derivatives for market participants. Page 6 of the report states: Derivatives serve an important function of the global financial marketplace, providing end-users with opportunities to better manage financial risks associated with their business transactions. The rapid growth and increasing complexity of derivatives reflect both the increased demand from end-users for better ways to manage their financial risks and the innovative capacity of the financial services industry to respond to market demands. Unfortunately, derivatives instruments are too often viewed by the general public—and sometimes regulators and legislative bodies—as vehicles for pure speculation (that is, legalized gambling). Without derivative instruments and the markets in which they trade, the financial systems throughout the world would not be as integrated as they are today. Financial Markets and the Real Economy In the introduction to this chapter, we explained how a market economy can be divided into two markets, the product market and the factor market. We then explained the critical role of financial markets in the efficient allocation of capital. Another way of looking at a market economy is by dividing it into two markets: (1) the real economy and (2) the paper economy. The real economy refers to markets where products and services are produced and their prices are determined. The paper economy refers to markets where financial assets are traded (i.e., financial markets) and the prices of these assets are determined. The financial markets include not just the cash market but derivatives markets. What is the linkage between the real economy and the paper economy? In the United States, there have been two well-known crises in the paper economy that have spilled over into the real economy, causing severe economic problems. On October 29, 1929 (“Black Monday”), the stock market crashed. The most popular stock market index at the time, the Dow Jones Industrial Average, fell by 25% in two days and by 30% in one week. The decline in the value of U.S. stocks resulted in millions of Americans losing a major part, if not all, of their wealth. This loss of wealth reduced consumer purchasing, which in turn forced business firms to reduce operations. In turn, this led to a further loss of jobs. The end result was the Great Depression, which lasted from 1929 to 1939, representing the longest economic depression in the United States. During this period, unemployment reached 20%, the gross domestic product fell by 30%, industrial production fell by 47%, and the consumer price index fell by 33% (i.e., the country experienced deflation). In addition, because of the lack of confidence in the banking system, numerous banks failed as a result of a run on the banks (i.e., many individuals simultaneously withdrawing deposits) and borrowers being unable to repay their loans (e.g., resulting in foreclosure on residential properties). In the 1920s, an average of 600 banks failed each year. In 1930, however, 1,350 banks either suspended or terminated their operations.4 The next year, 2,293 banks failed or suspended operations, and this number increased to almost 4,000 banks by 1933. It was during the Great Depression that major legislation involving bank regulation and financial markets were proposed by President Franklin Roosevelt and subsequently passed by Congress. Since then the legislation has been updated. The next major legislative changes dealing with financial markets came in 2008 as a result of what has been referred to variously as the global financial crisis or the global recession. In the summer of 2007, the market collapsed for certain financial instruments (one type of mortgage-backed securities, which we discuss in chapter 30). There was a spillover from this market to the real estate market, which experienced a pricing bubble owing to low interest rates and buyers’ belief in ever-increasing home prices. Banks and other financial institutions using excessive leverage5 and derivative products (such as credit default swaps) faced liquidity problems as the credit markets dried up. The bankruptcy of a major investment bank, Lehman Brothers, in 2008 was a key event that triggered the global financial crisis. The crisis resulted in a slowdown in economic growth and a high unemployment rate. There were fears of another Great Depression, not just in the United States but worldwide. In fact, while the United States experienced its worst recession since the Great Depression, such countries as France, Germany, and Japan realized the slowest economic growth in decades. These events led to legislation in many countries to reduce the likelihood of a problem in the paper economy leading to a severe economic crisis in the real economy. In the United States, the major legislation seeking to accomplish this was the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. As succinctly stated in this act, its intent is: To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail,” to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. We describe various provisions of this act, referred to simply as the “Dodd- Frank Act,” in later chapters. What is interesting is that despite the linkage observed between the paper economy and the real economy when the stock market crashed in 1929 and during the Great Depression that followed, it seems that macroeconomic models did not focus on this linkage until the 2008 financial crisis. As noted in a 2012 report by Germany’s central bank,6 the Deutsche Bundesbank: Prior to the crisis, financial markets were generally not included in macro models, nor was this regarded as necessary because, for the most part, the financial markets were not themselves deemed to contain any potential to cause disruptions. In the wake of the crisis, however, financial markets have been increasingly integrated into empirical and theoretical macroeconomic models.7 Key Points The financial system is composed of three parts: financial markets, financial institutions, and market infrastructure. A financial asset (financial instrument or security) entitles the owner to the future cash flow to be paid by the issuer. The holder of a financial asset’s claim can be either an equity or a debt claim. The value of any financial asset equals the present value of the expected cash flow. Three types of risk are associated with investing in financial assets: purchasing power or inflation risk, default or credit risk, and exchange-rate risk. The two principal economic functions of a financial asset are (1) to transfer funds from those who have surplus funds to invest to those who need funds to invest in tangible assets, and (2) to transfer funds in a way that redistributes the unavoidable risk associated with the cash flow generated by tangible assets among those seeking and those providing the funds.  Financial markets provide the following three additional functions beyond that of financial assets themselves: (1) They provide a mechanism for determining the price (or, equivalently, the required return) of financial assets; (2) they make assets more liquid; and (3) they reduce the costs of exchanging assets. The costs associated with market transactions are search costs and information costs. Financial markets can be classified by type of financial claim (debt instrument versus equity claim), by the maturity of claims (money market versus capital market), by whether the security is newly issued or seasoned (primary market versus secondary market), and by the type of organizational structure. Derivative instruments derive their value from an underlying financial asset. Derivative instruments allow market players to more efficiently accomplish their financial goals. Globalization means the integration of financial markets throughout the world into an international financial market and allows (1) entities in any country seeking to raise funds to look outside their domestic financial market and (2) investors in a country to invest in financial assets issued outside their domestic market. The factors contributing to the integration of financial markets include (1) deregulation or liberalization of markets and the activities of market participants in key financial centers of the world; (2) technological advances for monitoring world markets, executing orders, and analyzing financial opportunities; and (3) the increased institutionalization of financial markets. The institutionalization of financial markets refers to the shifting of the financial markets from dominance by retail investors to dominance by institutional investors. From the perspective of a given country, financial markets can be classified as either internal (or national) or external. A country’s internal market consists of its domestic market and foreign market.  A country’s domestic market is one in which issuers domiciled in the country issue securities and in which those securities are subsequently traded. In a country’s foreign market, securities of issuers not domiciled in the country are sold and traded. In classifying countries and stock markets as developed, emerging, or frontier, two characteristics are used: (1) their economic development (such as their per capita income and potential growth) and (2) the development of their capital markets in terms of market capitalization, the level of liquidity, and supporting regulatory and legal bodies. Developed stock markets are in countries that have higher levels of per capita income but lower potential growth. Developed stock markets are found mostly in North America, Western Europe, and Australasia, including the United States, Canada, Germany, the United Kingdom, Australia, New Zealand, and Japan. An emerging (developing) market is a market in a country that has some of the characteristics of a developed market, but not all of them. Developing countries include Brazil, Russia, India, and China (BRIC) and Portugal, Ireland, Italy, Greece, and Spain (PIIGS). A frontier or pre-emerging market is a market in a country that is too small and undeveloped to be considered an emerging market. Financial assets are grouped together into asset classes. The traditional asset classes include stocks, bonds, and cash equivalents. Nontraditional asset classes or alternative asset classes include real estate, commodities, private equities, hedge funds, venture capital, real assets, and currencies. The real economy is the market where products and services are produced and where the prices of those products and services are determined. The markets where financial assets are traded (i.e., financial markets) are referred to as the paper economy. Financial markets are linked to the real economy. Questions 1. What is the difference between a financial asset and a tangible asset? 2. What is the difference between the claim of a debtholder of Chevron Corporation and a common stockholder of Chevron Corporation? 3. What is the basic principle followed in determining the value of a financial asset? 4. Why is it difficult to determine the cash flow of a financial asset? 5. What factors affect the interest rate used to discount the cash flow expected from a financial asset? 6. Why are the characteristics of an issuer important in determining the price of a financial asset? 7. What are the two principal roles of financial assets? 8. In September 1990, a study by the U.S. Congress, Office of Technology Assessment, titled “Electronic Bulls & Bears: U.S. Securities Markets and Information Technology,” included the following statement: “Securities markets have five basic functions in a capitalistic economy: 1. they make it possible for corporations and governmental units to raise capital. 2. they help to allocate capital toward productive uses. 3. they provide an opportunity for people to increase their savings by investing in them. 4. they reveal investors’ judgments about the potential earning capacity of corporations, thus giving guidance to corporate managers. 5. they generate employment and income.” For each of the functions cited above, explain how financial markets (or securities markets, in the parlance of this Congressional study) perform each function. 9. A U.S. investor who purchases the bonds issued by the Japanese government makes the following comment: “Assuming that the Japanese government does not default, I know what the cash flow of the bond will be.” Explain why you agree or disagree with this statement. 10. Explain the difference between each of the following: a. money market and capital market b. primary market and secondary market c. domestic market and foreign market d. national market and Euromarket 11. Indicate whether each of the following instruments trades in the money market or the capital market: a. General Motors Acceptance Corporation issues a financial instrument with four months to maturity. b. The U.S. Treasury issues a security with 10 years to maturity. c. Microsoft Corporation issues common stock. d. The State of Mississippi issues a financial instrument with eight months to maturity. 12. A U.S. investor who purchases the bonds issued by the U.S. government makes the following statement: “By buying this debt instrument, I am not exposed to default risk or purchasing power risk.” Explain why you agree or disagree with this statement. 13. Explain why liquidity may depend not only on the type of financial asset but also on the quantity one wishes to sell or buy. 14. In 2016, McDonald’s issued in the Swiss bond market an eight-year bond denominated in Swiss francs (CHF). The par value was CHF 400 million. From the perspective of the Swiss financial market, indicate whether this issue is classified as being issued in the domestic market, the foreign market, or the offshore market. 15. Give three reasons for the trend toward greater integration of financial markets throughout the world. 16. What is meant by the “institutionalization” of capital markets? 17. a. How is an asset class defined? b. What are the traditional asset classes? 18. On August 25, 2017, the market capitalization of ExxonMobil was $324.73 billion. In terms of market cap, how would this company’s stock be classified? 19. On August 25, 2017, Facebook’s common stock closed at a price of $166.32 and the market cap of the company was $489.97 billion. What was the approximate number of shares outstanding? 20. What is the difference between an emerging stock market and a frontier stock market? 21. What are the two basic types of derivative instruments? 22. “Derivatives markets are nothing more than legalized gambling casinos and serve no economic function.” Comment on this statement. 1. The classification we use is by no means universally accepted. Some market observers and compilers of statistical data on market activity refer to the external market as consisting of the foreign market and the Euromarket. 2. “What Is the Difference between a Developed, Emerging, and Frontier Market?” May 11, 2012. http://www.nasdaq.com/article/what-is-the-difference-between-a-developed-emerging-and-frontier- market-cm140649. 3. Another way of classifying stocks in terms of asset classes is growth stocks and value stocks. Although the market cap of a company is easy to determine given the market price per share and the number of shares outstanding, defining “value” and “growth” stocks is not simple to do at this point in the book. We’ll describe value and growth stocks in chapter 23. 4. FDIC, Managing the Crisis: The FDIC and RTC Experience (Washington, DC: Federal Deposit Insurance Corporation, n.d.), http://www.fdic.gov/bank/historical/managing/Chron/pre-fdic. 5. We discuss the risks associated with leverage in chapter 10. 6. Central banks and their role are described in chapter 7. 7. Deutsche Bundesbank, “National and International Financial Market Shocks and the Real Economy: An Empirical View,” Monthly Report (March 2012): 35. 2 Role of Governments in Financial Markets CONTENTS Learning Objectives Macroprudential versus Microprudential Government Policies Regulation of Financial Markets Justification for Regulation Forms of Government Regulation of Financial Markets Regulation of disclosures Regulation of financial activities Regulation of financial institutions Governments as Financial Intermediaries Government Influence on Financial Markets through the Actions of the Central Bank Financial Stability and Monetary Policy Government Bailouts Forms of Bailouts Issues Associated with Government Bailouts Financial Regulators Outside the United States Germany France Switzerland Singapore Japan Other International Participants Bank for International Settlements Supranational Organizations Financial Stability Board Views on the Degree of Government Intervention in Financial Markets  Trump Administration’s View on Bank and Financial Regulation Key Points Questions Learning Objectives After reading this chapter, you will understand: what is meant by macroprudential policy and microprudential policy; the link between macroprudential policy and systemic financial risk; the justification for the regulation of financial regulation; the various roles governments play in the financial system; what a country’s central bank does; the role of monetary policy; what is meant by financial stability; the different forms of government bailouts, and the notion of “too big to fail”; what is meant by moral hazard when a financial institution’s management believes that the government will not allow it to fail; what systemically important financial institutions are, and the proposals for dealing with them; the objectives of the Bank for International Settlements, the Financial Stability Board, and supranational organizations; and the differing views on the degree of government intervention in the financial market. Financial markets play a prominent role in many economies, and governments around the world have long deemed it necessary to participate in various aspects of these markets. This is clear from the history of financial crises and resulting economic recessions that have occurred in modern capitalist economies. Governments play various roles in the financial system. They can do so in one or more of four ways. First, they can regulate financial markets, including financial intermediaries participating in the market. Second, they can act as financial intermediaries by making loans or guaranteeing loans to sectors or parts of the economy that are deemed to need assistance. Third, governments can influence financial markets at the macroeconomic level through the actions of their central banks. Finally, they can provide bailouts of or financial assistance to market sectors or corporations (financial and nonfinancial) during periods of market turmoil or distress. In this chapter, we explain the role of governments and government policies regarding financial markets. There is considerable ideological debate about the proper role that governments should play in financial markets, and in the last section of this chapter, we discuss that debate. U.S. financial regulations are described in several chapters in this book. Macroprudential versus Microprudential Government Policies Government policy dealing with a country’s financial system falls into two categories: macroprudential policy and microprudential policy. A government’s macroprudential policy seeks to reduce the risk to the financial system as a whole. The risk to the financial system is referred to as systemic financial risk or simply systemic risk. In general, the term systemic risk refers to the probability that an entire system will collapse or fail. When applied to finance, systemic risk is referred to as systemic financial risk. The key here is the interconnectedness of the financial system’s financial institutions and markets, as well as common exposures to economic factors, not only within a country but globally. In contrast to macroprudential policy, which focuses on the welfare of the entire financial system, microprudential policy seeks to control the risks associated with financial institutions. The interconnectedness of the financial institutions is not relevant here. As a result of the 2008–2009 global financial crisis, policymakers throughout the world have focused on macroprudential policy, as it became apparent during that crisis that focusing only on the safety of individual financial institutions is not adequate to protect the financial system as a whole. The following four causes of the financial crisis showed policymakers that appropriate response tools are needed to deal with systemic risk: (1) excessive use of leverage and risk taking, (2) a bubble in the pricing of assets in a key sector of the financial market (residential property), (3) regulatory and supervisory failures, and (4) widespread failure of market discipline. We describe these causes in the chapters to follow. As a result of this focus on macroprudential policy, the tools available to governments for implementing such policy and the impediments and challenges to the implementation of those tools by governments are now the subject of debate. The tools for implementing macroprudential policy are described later in this section. As for challenges, there are questions regarding whether governments should establish one supervisory entity to implement all macroprudential policy or share the responsibility among several supervisory entities. When a single supervisory entity is designated, that entity is typically the country’s central bank. Regulation of Financial Markets In their regulatory capacities, governments greatly influence the development and evolution of financial markets and institutions. It is important to realize that governments, issuers, and investors tend to interact and affect one another’s actions in certain ways. Thus, it is not surprising to find that a market’s reactions to regulations often prompt a new response by the government, which can cause the institutions in the market to change their behavior further, and so on. A sense of how the government can affect a market and its participants is important for understanding the numerous markets and securities that will be described in the chapters to come. Here we discuss regulations. Our purpose is not to provide a detailed account of the regulatory structures and rules. Rather, we provide a broad view of the goals and types of regulations, using the United States as our primary case, although we do mention regulations in other counties. Justification for Regulation The standard explanation or justification for governmental regulation of a market is that the market, left to itself, will not produce its particular goods or services in an efficient manner and at the lowest possible cost. Efficiency and low-cost production are hallmarks of a perfectly competitive market. Thus, a market unable to produce efficiently must be one that is not competitive at the time and will not gain that status by itself in the foreseeable future. Of course, it is also possible that governments might regulate markets that are viewed as competitive currently but are unable to sustain competition, and thus low-cost production, over the long run. A version of this justification for regulation is that the government controls a feature of the economy that the market mechanisms of competition and pricing could not manage without help. A shorthand expression used by economists to describe the reasons for regulation is market failure. A market is said to fail if it cannot, by itself, maintain all the requirements for a competitive situation. The regulatory structure in the United States is largely the result of financial crises that have occurred at various times. Until the 2008–2009 financial crisis, most regulatory mechanisms were the products of the stock market crash of 1929 and the Great Depression of the 1930s. Some of the regulations may make little economic sense in the current financial market, but they can be traced back to some abuse that legislators encountered, or thought they encountered, at one time. Further, in addition to financial institution regulation, three other forms of regulation are most often a function of the federal government, with state governments playing a secondary role. For that reason, the present discussion of regulation concentrates on the central government and any agencies it creates. Forms of Government Regulation of Financial Markets A government’s regulation of financial markets can take one or more of four forms: regulation of (1) disclosures, (2) financial activities, (3) financial institutions, and (4) foreign participants. Here we discuss each form of regulation. Regulation of disclosures Regulation of disclosures requires issuers of securities to make public a large amount of financial information to current and potential investors. The standard justification for disclosure rules is that the managers of the issuing firm have more information about the financial health and future of the firm than do investors who own or are considering the purchase of the firm’s securities. The cause of market failure here, if indeed it occurs, is commonly described as asymmetric information, which means investors and managers are subject to uneven access to or uneven possession of information. Also, the problem is said to be one of “agency,” in the sense that the firm’s managers, who act as agents for investors, may act in their own interests to the disadvantage of investors. The advocates of disclosure rules say that, in the absence of the rules, investors with comparatively limited knowledge about the firm would allow agents to engage in such practices. The United States is firmly committed to disclosure regulation. The Securities Act of 1933 and the Securities Exchange Act of 1934 led to the creation of the Securities and Exchange Commission (SEC), which is responsible for gathering and publicizing relevant information and for punishing those issuers who supply fraudulent or misleading data. However, none of the SEC’s requirements or actions constitutes a guarantee, a certification, or an approval of the securities being issued. Moreover, the government’s rules do not represent an attempt to prevent the issuance of risky assets. Instead, the government’s (and the SEC’s) sole motivation in this regard is to supply diligent and intelligent investors with the information needed for a fair evaluation of the securities. The need for disclosure regulation has been debated by economists. Some economists have denied the need and justification for disclosure rules, arguing that the securities market would, without governmental assistance, get all the information necessary for a fair pricing of new as well as existing securities.1 In this view, the securities laws supposedly extracting key data from agent-managers are redundant. One way to look at this argument is to ask what investors would do if a corporation trying to sell new shares did not provide all the data investors wanted. In that case, investors either would refuse to buy that corporation’s security, giving it a zero value, or would discount or underprice the security. Thus, a corporation concealing important information would pay a penalty in the form of reduced proceeds from the sale of a new security. The prospect of this penalty is potentially as much incentive to disclose as are the rules of a government agency, such as the SEC. Several studies have shown how management can benefit from voluntarily improved disclosure.2 Regulation of financial activities Regulation of financial activities consists of rules about traders of securities and trading on financial markets. A prime example of this form of regulation is the set of rules against trading by insiders who are corporate officers or others in positions to know more about a firm’s prospects than the general investing public. Insider trading is another problem posed by asymmetr