INTRODUCTION TO FINANCIAL ECONOMICS_174_272.pdf

INTRODUCTION TO FINANCIAL ECONOMICS FINANCIAL ECONOMICS INTRODUCTION TO FINANCIAL ECONOMICS – ECON 174/272 Background Individuals regularly make decisions to determine their consumption in future time periods, and most have income that varies...

INTRODUCTION TO FINANCIAL ECONOMICS FINANCIAL ECONOMICS INTRODUCTION TO FINANCIAL ECONOMICS – ECON 174/272 Background Individuals regularly make decisions to determine their consumption in future time periods, and most have income that varies over their lives. They initially consume from parental income before commencing work, whereupon their income normally increases until it peaks toward the end of their working life and then declines at retirement. When resources can be transferred between time periods the consumer can choose to smooth consumption expenditure (Xt ) to make it look like the dashed line in the diagram. Almost all consumption choices have intertemporal effects when individuals can transfer resources between time periods. Any good that provides (or funds) future consumption is referred to as a capital asset, and consumers trade these assets to determine the shape of the consumption profile. Individual initially sells capital assets (borrows) to raise consumption above income, and later purchases capital assets (saves) to repay debt and save for retirement and the payment of bequests. These trades smooth consumption expenditure relative to income, where consumption profiles are determined by consumer preferences, resources endowments and investment opportunities. There are physical and financial capital assets: physical assets such as houses and cars generate real consumption flows plus capital gains or losses, and financial assets have monetary payouts plus any capital gains or losses that can be converted into consumption goods. There are important links between them as many financial assets are used to fund investment in physical assets, where this gives them property right claims to their payouts. In frictionless competitive markets, asset values are a signal of the marginal benefits to sellers and marginal costs to buyers from trading future consumption. In effect, buyers and sellers are valuing the same payouts to capital assets when they make decisions to trade them, which is why so much effort is devoted to the derivation of capital asset pricing models in financial economics, particularly in the presence of uncertainty. Consumers will not pay a positive price for any asset unless it is expected to generate a net consumption flow for them in the future. In many cases these benefits might be reductions in consumption risk rather than increases in expected consumption. In fact, a large variety of financial securities trade in financial markets to facilitate trades in consumption risk. Financial economics is a challenging subject because it draws together analysis from a number of fields in economics. Indeed, modern macroeconomic analysis uses general equilibrium models with money and financial securities in a multi-period setting with uncertainty. Time and risk are fundamental characteristics of the environment every consumer faces. In recent years activity in capital markets has expanded dramatically to provide consumers with opportunities to trade risk and choose their intertemporal consumption. More and more people have become shareholders in private firms as they set aside funds for consumption in retirement. Professional traders in the capital market perform a variety of important services. Some gather information to find profitable investment opportunities, where this imposes constraints on firm managers and aligns their interests more closely to those of their investors. And by reducing trading costs they expand the aggregate consumption opportunities for the economy. Others specialize in trading insurance so that consumers can reduce individual risk from their consumption. Basis for Modern Economic Theory: 1 The optimization principle. People try to choose the best patterns of consumption they can afford, and/or 2 The equilibrium principle: prices adjust until the amount that people demand of something is equal to the amount that is supplied. UTILITY THEORY The primary goal of this Section is to increase your knowledge of individuals’ attitudes toward risk and how they make choices about consumption and savings. In short, the goal is to make you a better advisor. This section is about utility theory, which is a branch of microeconomics that studies individuals’ attitudes toward risk and how they make choices about consumption and savings. The goal of this section is to address the following questions: Why does an individual consume X and save Y? What is a utility function? How is it used to explain why an individual consumes X and saves Y? What are the implications of the Fisher Separation Theorem? What does it mean when we say “most individuals are risk-averse?” What are the implications of this statement? Do these same concepts apply when the decisions are about health care instead of finances? Objectives After you complete this section, you will be able to: Explain why a person consumes X and saves Y. Identify how the marginal rate of utility and marginal rate of investment return determine equilibrium of interest rates. Describe the utility functions of risk-averse, risk-neutral and risk-loving individuals. Explain risk premium. Explain why utility theory cannot always be used in health care decisions. Objectives This Section provides an introduction to financial economics. The goal of this section is to address the following questions: What is financial economics? Why do we study financial economics?  What are the major constructs of financial economics? Financial economics is the discipline underlying all financial services. No matter what your area of specialty or your role in your organization, an understanding of financial economics is essential. As you will learn in this module, financial economics is the study of how individuals and institutions acquire, save, and invest money. These activities are fundamental to institutions and individuals. What is 'Financial Economics' Foundations of modern financial economics; individuals' consumption and portfolio decisions under uncertainty; valuation of financial securities. Financial economics builds heavily on microeconomics and basic accounting concepts. In addition it requires familiarity with basic probability and statistics, since these are the standard tools used to measure and evaluate risk. Financial economics is primarily concerned with building models to derive testable or policy implications from acceptable assumptions. Some fundamental ideas in financial economics are portfolio theory, the Capital Asset Pricing Model. Portfolio theory studies how investors should balance risk and return when investing in many assets or securities. The Capital Asset Pricing Model describes how markets should set the prices of assets in relation to how risky they are. The Modigliani-Miller Theorem describes conditions under which corporate financing decisions are irrelevant for value, and acts as a benchmark for evaluating the effects of factors outside the model that do affect value. A branch of economics that analyzes the use and distribution of resources in markets in which decisions are made under uncertainty. Financial decisions must often take into account future events, whether those be related to individual stocks, portfolios or the market as a whole. Financial economics employs economic theory to evaluate how time, risk (uncertainty), opportunity costs and information can create incentives or disincentives for a particular decision. Financial Economics studies investor preferences and how they affect the trading and pricing of financial assets like stocks, bonds, and real estate. The two most important investor preferences are a desire for high rates of return and a dislike of risk and uncertainty. This note will explain how these preferences interact to compensate for higher levels of risk with higher rates of return. This relationship is enforced by a powerful set of buying and selling pressures known as arbitrage, which ensures consistency across investments so that assets with identical levels of risk generate identical rates of return. As we will demonstrate, this consistency makes it extremely difficult for anyone to “beat the market” by finding a set of investments that can generate high rates of return at low levels of risk. Instead, investors are stuck with the need to make a tradeoff. If they want higher rates of return, they must accept higher levels of risk. Financial economics is a branch of economics that focuses on the allocation of resources in financial markets. It combines principles from both economics and finance to analyze how individuals, businesses, and governments make decisions regarding the use of financial resources. The primary goal of financial economics is to understand and explain the mechanisms that drive financial markets, asset prices, and the overall allocation of capital in an economy. Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment". It is additionally characterized by its "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". The questions within financial economics are typically framed in terms of "time, uncertainty, options, and information"] ▪ Time: money now is traded for money in the future. ▪ Uncertainty (or risk): The amount of money to be transferred in the future is uncertain. ▪ Options: one party to the transaction can make a decision at a later time that will affect subsequent transfers of money. ▪ Information: knowledge of the future can reduce, or possibly eliminate, the uncertainty associated with future monetary value (FMV). Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It studies the following: ▪ Valuation - Determination of the fair value of an asset ▪ How risky is the asset? (identification of the asset appropriate discount rate) ▪ What cash flows will it produce? (discounting of relevant cash flows) ▪ How does the market price compare to similar assets? (relative valuation) ▪ Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation) ▪ Financial markets and Instruments ▪ Commodities ▪ Stocks ▪ Bonds ▪ Money market instruments ▪ Derivatives Financial economics concentrates on decision making when two considerations are particularly important: 1. first, some of the outcomes are risky; 2. second, both the decisions and the outcomes may occur at different times. The subject is usually applied to investment decisions, particularly in financial markets (hence the name) such as the stock market, but it also has close links to the parts of microeconomics connected with insurance and saving. Financial Economics has many aspects. Two of the most important are: Discounting: Decision making over time recognises the fact that the value of £1 in ten years’ time is less than the value of £1 now. The £1 ten years’ hence must be discounted to allow for risk, inflation and the simple fact that it is in the future. Failure to discount appropriately has led to problems such as the systematic underfunding of pension schemes that we have seen in recent years. Risk management and diversification: Many advertisements for financial products based on the stock market remind potential buyers that the value of investments may fall as well as rise. So although stocks yield a return which is high on average, this is largely to compensate for risk. Financial institutions are always looking for ways of insuring (or ‘hedging’) this risk. It is sometimes possible to hold two highly risky assets but for the overall risk to be low: if share A only performs badly when share B performs well (and vice versa) then the two shares perform a perfect ‘hedge’. An important part of finance is working out the total risk of a portfolio of risky assets, since the total risk may be less than the risk of the individual components. KEY COMPONENTS OF FINANCIAL ECONOMICS INCLUDE: 1. Asset Pricing: Examines how financial assets (such as stocks and bonds) are priced in the market. It seeks to understand the factors influencing asset prices and how they reflect the present value of future cash flows. 2. Portfolio Theory: Investigates how investors can construct portfolios to optimize returns while managing risk. This involves diversification and the trade-off between risk and return. 3. Capital Markets: Studies the functioning of financial markets, including stock exchanges and bond markets. It explores the role of financial intermediaries, such as banks and investment firms, in facilitating the flow of funds between savers and borrowers. 4. Corporate Finance: Analyzes the financial decisions made by companies, including investment decisions, financing strategies, and dividend policies. It explores how these decisions impact the overall value of the firm. 5. Behavioral Finance: Integrates insights from psychology into financial economics to understand how psychological factors and biases influence financial decision-making. IMPORTANCE OF FINANCIAL ECONOMICS Financial economics holds significant importance in various aspects of the economy, finance, and decision-making. Here are several key reasons highlighting the importance of financial economics: 1. Resource Allocation and Efficiency: Financial economics aids in the efficient allocation of resources by providing insights into how capital is distributed among different investment opportunities.  Efficient resource allocation contributes to economic growth, as funds flow towards productive ventures, stimulating innovation and development. 2. Investment Decision-Making: Individuals, businesses, and governments make investment decisions based on financial economic principles. Understanding risk, return, and market dynamics is crucial for making informed investment choices. Financial economics provides tools such as discounted cash flow analysis, capital budgeting, and risk assessment to optimize investment decisions. 3. Risk Management: Financial economics helps individuals and organizations manage risk by providing models and frameworks for risk assessment and mitigation. Through diversification, hedging, and other risk management strategies, financial economics contributes to reducing the impact of uncertainties on financial portfolios. 4. Corporate Finance: Companies use financial economics principles to make decisions regarding capital structure, investment projects, and dividend policies. Financial economics guides corporate financial strategies, optimizing the balance between equity and debt, and determining the most efficient use of available funds. 5. Market Functioning and Regulation: Understanding financial economics is essential for the design and implementation of regulatory frameworks that ensure the stability, transparency, and integrity of financial markets. Policymakers use insights from financial economics to create rules and regulations that protect investors, maintain market efficiency, and prevent financial crises. 6. Economic Policy: Financial economics provides a foundation for policymakers in formulating monetary and fiscal policies to address economic challenges. Insights from financial economics contribute to the management of inflation, unemployment, and overall economic stability. 7. Behavioral Finance: Behavioral finance, a subfield of financial economics, incorporates psychological factors into economic decision-making models. This is important for understanding market anomalies and investor behavior.  Recognizing behavioral biases helps market participants make more realistic assessments of market trends and risks. 8. Innovation and Development: Financial innovation, often driven by financial economic theories, leads to the creation of new financial instruments, markets, and technologies. This innovation can enhance liquidity, provide new investment opportunities, and contribute to the development of the financial sector. 9. Global Financial Stability: Financial economics contributes to global financial stability by providing frameworks for assessing systemic risks and coordinating international financial policies. In conclusion, financial economics is essential for individuals, businesses, governments, and policymakers in making sound financial decisions, managing risks, and promoting overall economic stability and growth. It serves as a foundation for understanding the intricate dynamics of financial markets and guiding actions that have far-reaching implications for economies at both micro and macro levels. WHAT ARE THE BASIC CONCEPTS IN FINANCIAL ECONOMICS Financial economics involves a range of basic concepts that form the foundation for understanding the behavior of financial markets, the allocation of resources, and decision-making in the realm of finance. Here are some fundamental concepts in financial economics: 1. Time Value of Money (TVM): The concept that a sum of money has different values at different points in time. It forms the basis for discounting future cash flows to their present value and is crucial for valuation and investment decisions. 2. Risk and Return: The fundamental trade-off between risk and return. Investors expect higher returns for taking on higher levels of risk. Understanding and managing this trade-off is essential in making investment decisions. 3. Present Value and Future Value: Present value is the current worth of a sum of money, considering its future value and a discount rate. Future value is the value of an investment at a specific future date, taking into account compounding. 4. Capital Budgeting:  The process of evaluating and selecting investment projects that involve capital expenditures. Techniques such as Net Present Value (NPV) and Internal Rate of Return (IRR) are used to assess the profitability of these projects. 5. Efficient Market Hypothesis (EMH): The idea that financial markets efficiently incorporate and reflect all relevant information. EMH suggests that it is difficult to consistently achieve above-average returns by exploiting market information. 6. Portfolio Theory: Developed by Harry Markowitz, portfolio theory involves the diversification of investments to optimize returns while minimizing risk. It explores the relationship between individual assets and the overall portfolio. 7. Arbitrage: The process of taking advantage of price differentials in different markets to make a profit with no net investment. Arbitrage opportunities help ensure that markets remain efficient. 8. Capital Asset Pricing Model (CAPM): CAPM is a model that describes the relationship between systematic risk (beta) and expected return on an asset. It provides a framework for determining the appropriate required rate of return for an investment. 9. Dividend Policy: The decision-making process by which a company determines the amount of dividends to be distributed to its shareholders. It involves balancing the company's need for retained earnings with the expectations of shareholders. 10. Options and Derivatives: Financial instruments whose values are derived from an underlying asset. Understanding options and derivatives is crucial for managing risk and speculation in financial markets. 11. Liquidity: The ease with which an asset can be bought or sold in the market without affecting its price. Liquidity is a key consideration for investors and is vital for the efficient functioning of financial markets. 12. Agency Theory:  Examines the relationship between principals (such as shareholders) and agents (such as managers) and the challenges arising from divergent interests. It helps in understanding and mitigating agency problems in corporate finance. 13. Behavioral Finance: Incorporates psychological factors and biases into financial decision-making models. It explores how individual and collective behavior can deviate from traditional economic assumptions. These basic concepts provide a framework for analyzing financial markets, making investment decisions, and understanding the factors that influence the allocation of resources in the financial realm. They are essential for practitioners, investors, policymakers, and anyone involved in the field of financial economics. Terms and Concepts Economic investment Risk premium Financial investment Compound interest Present value Underlying Assets Derivatives Futures and Forwards Options Stocks Bankrupt Limited liability rule Capital gains Dividends Bonds Default Mutual funds Portfolios Index funds Actively managed funds Passively managed funds Percentage rate of return Arbitrage Risk Diversification Diversifiable risk Non-diversifiable risk Average expected rate of return Probability weighted average Beta Market portfolio Time preference Risk-free interest rate Security Market Line Financial Investment Financial economics focuses its attention on the investments that individuals and firms make in the wide variety of assets available to them in our modern economy. But before proceeding, it is important for you to recall the difference between economic investment and financial investment. Economic Investment refers to paying for new additions to the nation’s capital stock. Thus, newly built roads, bridges, wireless networks, factories, and houses are all examples of economic investment. In contrast, financial investment refers to either buying or building an asset in the expectation that doing so will generate a financial gain. Since the definition of financial investment does not distinguish between assets that are new additions to the nation’s capital stock and assets that have long existed, purchasing an old house is just as much a financial investment as is purchasing a new house, and purchasing an old factory is just as much a financial investment as is building a new factory. When bankers, entrepreneurs, corporate executives, retirement planners, and ordinary people use the word “investment,” they almost always mean financial investment. In fact, the ordinary meaning of the word investment is financial investment. Present Value One of the fundamental ideas in financial economics is present value—the present-day value, or worth, of returns or costs that are expected to arrive in the future. The ability to calculate present values is especially useful when investors wish to determine the proper current price to pay for an asset: As we will explain in detail, an investment’s proper current price is simply equal to the present value of the investment’s expected future returns. The best way to understand present value is to first understand the idea of compound interest. Underlying Assets Underlying assets can be stocks, bonds, currency, commodities, and other financial assets, or combinations of these. The traditional stock and bond markets raise necessary capital for corporations and governments, and the foreign exchange market facilitates international trade and investment. Derivative Assets Derivatives are financial instruments that take their value from the prices of one or more other assets such as stocks, bonds, foreign currencies, or commodities. Derivatives serve as tools for managing risks associated with these underlying assets. The most common types of derivatives are options and futures. Forwards and Futures A forward is a financial contract in which two parties agree to buy and sell a certain amount of the underlying commodity or financial asset at a pre-specified price at a specified time in the future. The specified time is called the time-to-maturity of the forward contract and the price specified in the contract is called the forward price. Options An option is a financial contract, which provides the holder with the right to buy or sell a certain amount of the underlying asset at a pre-specified price at or before a specified time in the future. Example Say you decide to buy a new car. Dealer tells you that if you place the order today and place a deposit, then you can take delivery of the car in 3 months time. If in 3 months time the price of the model has decreased or increased, it doesn’t matter. When the agreement between you and the dealer is reached, you have entered into a forward contract: you have the right and also the obligation to buy the car in 3 months. Instead, suppose the car you selected is on offer at 30,000 euros but you must buy it today. You don’t have that amount of cash today and it will take a week to organize a loan. You could offer the dealer a deposit, for example 200 Euros, if he will just keep the car for a week and hold the price. During the week, you might discover a second dealer offering an identical model for a lower price, then you don’t take up your option with the first dealer. At the end of the week the 200 Euros is the dealer’s whether you buy the car, or not. In this case, you have entered an option contract, a call option here. It means that you have the right to buy the car in a week, but not the obligation. The expiration time is one week from now, the strike price is 30,000 Euros. Risk and Return One aside: There is a fundamental assumption that with a higher amount of risk must come a higher rate of return on any asset–it would be irrational to hold a riskier asset than you desire for less return than doing something else with your cash. This view, assumes you know a lot about other assets, and it is something we’ll return to in much more detail later on. Time Value Time value of money refers to the fact that money in hand today is worth more than the expectation of the same amount to be received in the future. Money has a time value because of the opportunity to earn interest or the cost of paying interest on borrowed capital. Where is time value in our example? Compounding - the process of going from today’s value, or present value (PV), to future value (FV). Future value is the amount of money an investment will grow to at some date in the future by earning interest at some compound rate. If is the interest rate and n is the number of years, the future value of a present value is given by: FV = PV / (1 + i)t Compound Interest Compounding - the process of going from today’s value, or present value (PV), to future value (FV). Compound interest describes how quickly an investment increases in value when interest is paid, or compounded, not only on the original amount invested but also on all interest payments that have been previously made. Consequently, the compound interest formula given in equation 1 defines not only the rate at which present amounts of money can be converted to future amounts of money but also the rate at which future amounts of money can be converted into present amounts of money. We exploit the latter ability in the next section to develop the present value model. The Present Value Model If an investor is considering buying an asset, her problem is to try to determine how much she should pay today to buy the asset and receive those future payments. CK REVIEW 14W.1 Financial investment refers to buying an asset with the hope of financial gain. Compound interest is the payment of interest not only on the original amount invested but also on any interest payments previously made; X dollars today growing at interest rate i will become (1 _ i ) t X dollars in t years. The present value formula facilitates transforming future amounts of money into present-day amounts of money; X dollars in t years converts into exactly X _(1 _ i ) t dollars today. An investment’s proper current price is equal to the sum of the present values of all the future payments that it is expected to make. Applications Present value is not only an important idea for understanding investment, but it has many everyday applications. Let’s examine two of them. Stocks Stocks represent the claim of the owners of a firm. Stocks are issued by corporations and can be traded in the stock market. Common stock usually entitles the shareholder to vote in the election of directors and other matters. Recall that stocks are ownership shares in a corporation. If an investor owns 1 percent of a corporation’s shares, she gets 1 percent of the votes at the shareholder meetings that select the company’s managers and she is also entitled to 1 percent of any future profit distributions. There is no guarantee, however, that a company will be profitable. Firms often lose money and sometimes even go bankrupt. Bankrupt By definition it means when a firm is unable to make timely payments on their debts. In the event of a bankruptcy, control of a corporation’s assets is given to a bankruptcy judge, whose job is to enforce the legal rights of the people who lent the company money by doing what he can to see that they are repaid. Typically, this involves selling off the corporation’s assets (factories, real estate, patents, etc.) to raise the money necessary to pay off the company’s debts. The money raised by selling the assets may be greater than or less than what is needed to fully pay off the firm’s debts. If it is more than what is necessary, any remaining money is divided equally among shareholders. If it is less than what is necessary, then the lenders do not get repaid in full and have to suffer a loss. Limited Liability rule A key point, however, is that the maximum amount of money that shareholders can lose is what they pay for their shares. If the company goes bankrupt owing more than the value of the firm’s assets, shareholders do not have to make up the difference. This limited liability rule limits the risks involved in investing in corporations and encourages investors to invest in stocks by capping their potential losses at the amount that they paid for their shares. Capital Gains When firms are profitable, however, investors can look forward to gaining financially in either or both of two possible ways. The first is through capital gains , meaning that they sell their shares in the corporation for more money than they paid for them. The second is by receiving dividends, which are equal shares of the corporation’s profits. As we will soon explain, a corporation’s current share price is determined by the size of the capital gains and dividends that investors expect the corporation to generate in the future. Bonds Bonds are issued by anyone who borrows money - firms, governments, etc. They are fixed-income instruments because they promise to pay fixed sums of cash in the future. Bondholders have an IOU (I owe you) from the issuer, but no corporate ownership privileges, as stockholders do. Bonds are debt contracts that are issued most frequently by governments and corporations. They typically work as follows: An initial investor lends the government or the corporation a certain amount of money, say N1,000, for a certain period of time, say 10 years. In exchange, the government or corporation promises to make a series of semiannual payments in addition to returning the N1,000 at the end of the 10 years. These payments constitute interest on the loan. For instance, the bond agreement may specify that the borrower will pay N30 every six months. This means that the bond will pay N60 per year in payments, which is equivalent to a 6 percent rate of interest on the initial N1,000 loan. The initial investor is free, however, to sell the bond at any time to other investors, who then gain the right to receive any of the remaining semiannual payments as well as the final N1,000 payment when the bond expires after 10 years. As we will soon demonstrate, the price at which the bond will sell if it is indeed sold to another investor will depend on the current rates of return available on other investments offering a similar stream of future payments and facing a similar level of risk. Default The primary risk a bondholder faces is the possibility that the corporation or government which issues his bond will default on, or fail to make, the bond’s promised payments. This risk is much greater for corporations, but it also faces local and state governments in situations where they cannot raise enough tax revenue to make their bond payments or where defaulting on bond payments is politically easier than reducing spending on other items in the government’s budget to raise the money needed to keep making bond payments. The Federal government, however, has never defaulted on its bond payments and is very unlikely to ever default for the simple reason that it has the right to print money and can therefore just print whatever money it needs to make its bond payments on time. A key difference between bonds and stocks is that bonds are much more predictable. Unless a bond goes into default, its owner knows both how big its future payments will be and exactly when they will arrive. By contrast, stock prices and dividends are highly volatile because they depend on profits, which vary greatly depending on the overall business cycle and on factors specific to individual firms and industries— things such as changing consumer preferences, variations in the costs of inputs, and changes in the tax code. As we will demonstrate later, the fact that bonds are typically more predictable (thus less risky) than stocks explains why they generate lower average rates of return than stocks. Indeed, this difference in rates of return has been very large historically. Mutual Funds A mutual fund is a company that maintains a professionally managed portfolio , or collection, of either stocks or bonds. The portfolio is purchased by pooling the money of many investors. Since these investors provide the money to purchase the portfolio, they own it and any gains or losses generated by the portfolio flow directly to them. Index Funds In addition, there are index funds , whose portfolios are selected to exactly match a stock or bond index. Indexes follow the performance of a particular group of stocks or bonds in order to gauge how well a particular category of investments is doing. For instance, the Standard & Poor’s 500 Index contains the 500 largest stocks trading in the United States in order to capture how the stocks of large corporations vary over time, while the Lehman 10-Year Corporate Bond Index follows a representative collection of 10-year corporate bonds to see how well corporate bonds do over time. An important distinction must be drawn between actively managed and passively managed mutual funds. Actively Managed Funds and Passively Managed Funds Actively managed funds have portfolio managers who constantly buy and sell assets in an attempt to generate high returns. By contrast, index funds are passively managed funds because the assets in their portfolios are chosen to exactly match whatever stocks or bonds are contained in their respective underlying indexes. Later in the chapter, we will discuss the relative merits of actively managed funds and index funds, but for now we merely point out that both types are very popular and that, overall, investors had placed N8.9 trillion into mutual funds by the end of 2005. By way of comparison, U.S. GDP in 2005 was N12.5 trillion and the estimated value of all the financial assets held by households in 2005 (including everything from real estate to checking account deposits) was N38.5 trillion. Calculating Investment Returns Investors buy assets in order to obtain one or more future payments. The simplest case is purchasing an asset for resale. For instance, an investor may buy a house for N300,000 with the hope of selling it for N360,000 in one year. On the other hand, he could also rent out the house for N3000 per month and thereby receive a stream of future payments. And he could of course do a little of both, paying N300,000 for the house now in order to rent it out for five years and then sell it. In that case, he is expecting a stream of smaller payments followed by a large one. Economists have developed a common framework for evaluating the gains or losses of assets that only make one future payment as well as those that make many future payments. This is to state the gain or loss as a percentage rate of return. Percentage Rate of Returns by which they mean the percentage gain or loss (relative to the buying price) over a given period of time, typically a year. For instance, if a person buys a rare comic book today for N100 and sells it in 1 year for N125, she is said to make a 25 percent per year rate of return because she would divide the gain of N25 by the purchase price of N100. By contrast, if she were only able to sell it for N92, then she would be said to have made a loss of 8 percent per year since she would divide the N8 loss by the purchase price of N100. A similar calculation is made for assets that deliver a series of payments. For instance, an investor who buys a house for N300,000 and expects to rent it out for N3000 per month would be expecting to make a 12 percent per year rate of return because he would divide his N36,000 per year in rent by the N300,000 purchase price of the house. Asset Prices and Rates of Return A very fundamental concept in financial economics is that an investment’s rate of return is inversely related to its price. That is, the higher the price, the lower the rate of return. To see why this is true, consider a house that is rented out for N2000 per month. If an investor pays N100,000 for the house, he will earn a 24 percent per year rate of return since the N24,000 in annual rents will be divided by the N100,000 purchase price of the house. But suppose that the purchase price of the house rises to N200,000. In that case, he would earn only a 12 percent per year rate of return since the N24,000 in annual rents would be divided by the much larger purchase price of N200,000. Consequently, as the price of the house goes up, the rate of return from renting it out goes down. The underlying cause of this inverse relationship is the fact that the rent payments are fixed in value so that there is an upper limit to the financial rewards of owning the house. As a result, the more an investor pays for the house, the lower his rate of return will be. Arbitrage Arbitrage happens when investors try to take advantage and profit from situations where two identical or nearly identical assets have different rates of return. They do so by simultaneously selling the asset with the lower rate of return and buying the asset with the higher rate of return. For instance, consider what would happen in a case where two very similar T-shirt companies start with different rates of return despite the fact that they are equally profitable and have equally good future prospects. To make things concrete, suppose that a company called T4me starts out with a rate of return of 10 percent per year while TSTG (T-Shirts to Go) starts out with a rate of return of 15 percent per year. Since both companies are basically identical and have equally good prospects, investors in T4me will want to shift over to TSTG, which offers higher rates of return for the same amount of risk. As they begin to shift over, however, the prices of the two companies will change— and with them, the rates of return on the two companies. In particular, since so many investors will be selling the shares of the lower return company, T4me, the supply of its shares trading on the stock market will rise so that its share price will fall. But since asset prices and rates of return are inversely related, this will cause its rate of return to rise. At the same time, however, the rate of return on the higher return company, TSTG, will begin to fall. This has to be the case because, once again, asset prices and rates of return are inversely related. As the price of TSTG goes up, its rate of return must fall. The interesting thing is that this arbitrage process will continue—with the rate of return on the higher return company falling and the rate of return on the lower return company rising—until both companies have the same rate of return. This has to be the case because as long as the rates of return on the two companies are not identical, there will always be some investors who will want to sell the shares of the lower returning company in order to buy the shares of the higher returning company. As a result, arbitrage will continue until the rates of return are equal. What is even more impressive, however, is that generally only a very short while is needed for prices to equalize. In fact, for highly traded assets like stocks and bonds, arbitrage will often force the rates of return on identical or nearly identical investments to converge within a matter of minutes or sometimes even within a matter of seconds. This is very helpful to small investors who do not have large amount of time to study the thousands of potential investment opportunities available in the financial markets. Portfolio Portfolio, something good will be happening to another part of the portfolio and the two effects will tend to offset each other. Thus, the risk to the overall portfolio is reduced by diversification. It must be stressed, however, that while diversification can reduce a portfolio’s risks, it cannot eliminate them entirely. The problem is that even if an investor has placed each of his eggs into a different basket, all of the eggs may still end up broken if all of the different baskets somehow happen to get dropped simultaneously. That is, even if an investor has created a well-diversified portfolio, all of the investments still have a chance to do badly simultaneously. As an example, consider recession: With economic activity declining and consumer spending falling, nearly all companies face reduced sales and lowered profits, a fact that will cause their stock prices to decline simultaneously. Consequently, even if an investor has diversified his portfolio across many different stocks, his overall wealth is likely to decline because nearly all of his many investments will do badly simultaneously. Financial economists build on the intuition behind the benefits and limits to diversification to divide an individual investment’s overall risk into two components, diversifiable risk and non diversifiable risk. Diversifiable risk (or “idiosyncratic risk”) is the risk that is specific to a given investment and which can be eliminated by diversification. For instance, a soda pop maker faces the risk that the demand for its product may suddenly decline because people will want to drink mineral water instead of soda pop. But this risk does not matter if an investor has a diversified portfolio that contains stock in the soda pop maker as well as stock in a mineral water maker. This is true because when the stock price of the soda pop maker falls due to the change in consumer preferences, the stock price of the mineral water maker will go up—so that, as far as the overall portfolio is concerned, the two effects will offset each other. Non-diversifiable risk (or “systemic risk”) pushes all investments in the same direction at the same time so that there is no possibility of using good effects to offset bad effects. The best example of a non-diversifiable risk is the business cycle. If the economy does well, then corporate profits rise and nearly every stock does well. But if the economy does badly, then corporate profits fall and nearly every stock does badly. As a result, even if one were to build a well-diversified portfolio, it would still be affected by the business cycle because nearly every asset contained in the portfolio would move in the same direction at the same time whenever the economy improved or worsened. QUICK REVIEW 14W.2 Three popular forms of financial investments are stocks (ownership shares in corporations that give their owners a share in any future profits), bonds (debt contracts that promise to pay a fixed series of payments in the future), and mutual funds (pools of investor money used to buy a portfolio of stocks or bonds). Investment gains or losses are typically expressed as a percentage rate of return: the percentage gain or loss (relative to the investment’s purchase price) over a given period of time, typically a year. Asset prices and percentage rates of return are inversely related. Arbitrage refers to the buying and selling that takes place to equalize the rates of return on identical or nearly identical assets. Risk Investors purchase assets in order to obtain one or more future payments. As used by financial economists, the word risk refers to the fact that investors never know with total certainty what those future payments will turn out to be. The underlying problem is that the future is uncertain. Many factors affect an investment’s future payments, and each of these may turn out better or worse than expected. As a simple example, consider buying a farm. Suppose that in an average year, the farm will generate a profit of N100,000. But if a freak hailstorm damages the crops, the profit will fall to only N60,000. On the other hand, if weather conditions turn out to be perfect, the profit will rise to N120,000. Since there is no way to tell in advance what will happen, investing in the farm is risky. Diversification Investors have many options regarding their portfolios, or collections of investments. Among other things, they can choose to concentrate their wealth in just one or two investments or spread it out over a large number of investments. Diversification is the name given to the strategy of investing in a large number of investments in order to reduce the overall risk to the entire portfolio. The underlying reason that diversification works is best summarized by the old saying, “Don’t put all your eggs in one basket.” If an investor’s portfolio consists of only one investment, say one stock, then if anything awful happens to that stock, the investor’s entire portfolio will suffer greatly. By contrast, if the investor spreads his wealth over many stocks, then a bad outcome for any one particular stock will cause only a small amount of damage to the overall portfolio. In addition, it will typically be the case that if something bad is happening to one part of the That being said, creating a diversified portfolio is still an investor’s best strategy because doing so at least eliminates diversifiable risk. Indeed, it should be emphasized that for investors who have created diversified portfolios, all diversifiable risks will be eliminated, so that the only remaining source of risk will be nondiversifiable risk. An extremely important implication of this fact is that when an investor considers whether to add any particular investment to a portfolio that is already diversified, she can ignore the investment’s diversifiable risk. She can ignore it because, as part of a diversified portfolio, the investment’s diversifiable risk will be eliminated. Indeed, the only risk left will be the amount of nondiversifiable risk that the investment carries with it. This is very important because it means that investors can base their decisions about whether to add a new investments to their portfolios by comparing levels of nondiversifiable risk with potential returns. If they find this tradeoff attractive, they will add the investment, whereas if it seems unattractive, they will not. Comparing Risky Investments Economists believe that the two most important factors affecting investment decisions are returns and risk—specifically nondiversifiable risk. But for investors to properly compare different investments on the basis of returns and risk, they need ways to measure returns and risk. The two standard measures are, respectively, the average expected rate of return and the beta statistic. Average Expected Rate of Return Each investment’s average expected rate of return is the probability weighted average of the investment’s possible future rates of return. The term probability weighted average simply means that each of the possible future rates of return is multiplied by its probability expressed as a decimal (so that a 50 percent probability is.5 and a 23 percent probability is.23) before being added together to obtain the average. For instance, if an investment is equally likely to return 11 percent per year or 15 percent per year, then its average expected rate of return will be 13 percent _ (.5 _ 11 percent) _ (.5 _ 15 percent). By weighting each possible outcome by its probability, this process ensures that the resulting average gives more weight to those outcomes that are more likely to happen (unlike the normal averaging process that would treat every outcome the same). Once investors have calculated the average expected rates of return for all the assets they are interested in, there will naturally be some impulse to simply invest in those assets having the highest average expected rates of return. But while this might satisfy investor cravings for higher rates of return, it would not take proper account of the fact that investors dislike risk and uncertainty. To quantify their dislike, investors require a statistic that can measure each investment’s risk level. Beta One popular statistic that serves this purpose is called beta. Beta is a relative measure of nondiversifiable risk. It measures how the nondiversifiable risk of a given asset or portfolio of assets compares with that of the market portfolio , which is the name given to a portfolio that contains every asset available in the financial markets. The market portfolio is a useful standard of comparison because it is as diversified as possible. In fact, since it contains every possible asset, every possible diversifiable risk will be diversified away—meaning that it will be exposed only to nondiversifiable risk. Consequently, it can serve as a useful benchmark against which to measure the levels of nondiversifiable risk to which individual assets are exposed. Another useful feature of beta is that it can be calculated not only for individual assets but also for portfolios. Indeed, it can be calculated for portfolios no matter how many or how few assets they contain and no matter what those assets happen to be. This fact is very convenient for mutual fund investors because it means that they can use beta to quickly see how the nondiversifiable risk of any given fund’s portfolio compares with that of other potential investments that they may be considering. The beta statistic is used along with average expected rates of return to give investors standard measures of return and risk that can be used to sensibly compare different investment opportunities. Relationship of Risk and Average Expected Rates of Return The fact that investors dislike risk has a profound effect on asset prices and average expected rates of return. In particular, their dislike of risk and uncertainty causes investors to pay higher prices for less risky assets and lower prices for more risky assets. But since asset prices and average expected rates of return are inversely related, this implies that less risky assets will have lower average expected rates of return than more risky assets. Stated a bit more clearly, risk levels and average expected rates of return are positively related. The more risky an investment is, the higher its average expected rate of return will be. A great way to understand this relationship is to think of higher average expected rates of return as being a form of compensation. In particular, since investors dislike risk, they demand higher levels of compensation the more risky an asset is. The higher levels of compensation come in the form of higher average expected rates of return. Be sure to note that this phenomenon affects all assets. Regardless of whether the assets are stocks or bonds or real estate or anything else, assets with higher levels of risk always end up with higher average expected rates of return to compensate investors for the higher levels of risk involved. No matter what the investment opportunity is, investors examine its possible future payments, determine how risky they are, and then select a price that reflects those risks. Since less risky investments get higher prices, they end up with lower rates of return, whereas more risky investments end up with lower prices and, consequently, higher rates of return. Time preference refers to the fact that because people tend to be impatient, they typically prefer to consume things in the present rather than in the future. Stated more concretely, most people, if given the choice between a serving of their favorite dessert immediately or a serving of their favorite dessert in five years, will choose to consume their favorite dessert immediately. This time preference for consuming sooner rather than later affects the financial markets because people want to be compensated for delayed consumption. GLOBAL PERSPECTIVE 14W.1 WHAT ARE FINANCIAL MARKETS AND FINANCIAL INSTRUMENTS Financial Markets: Financial markets are platforms or systems that facilitate the buying and selling of financial instruments, commodities, and other fungible items. These markets bring together buyers and sellers to enable the exchange of assets and determine their prices. These financial instruments are crucial for investors, businesses, and governments to manage their financial resources, hedge risks, and participate in the capital markets. The diversity of financial instruments allows market participants to tailor their investment and risk management strategies to meet specific financial objectives. Financial markets play a crucial role in the allocation of capital, providing liquidity, and facilitating risk management. There are various types of financial markets, broadly categorized into: 1. Capital Markets: Stock Markets: Where equities (stocks) are bought and sold. Bond Markets: Where debt securities (bonds) are traded. 2. Money Markets: Deal with short-term debt instruments and provide a platform for borrowing and lending with maturities typically less than a year.  3. Derivatives Markets: Involve financial contracts whose value is derived from an underlying asset, index, or rate. Examples include options and futures contracts. 4. Foreign Exchange Markets: Facilitate the trading of different national currencies. 5. Commodity Markets: Deal with the buying and selling of physical commodities such as gold, oil, agricultural products, etc. Financial Instruments: Financial instruments are contracts or documents that represent a financial claim, ownership, or liability. These instruments can be traded in financial markets and serve as a means for investors to buy or sell various types of assets. Financial instruments can be categorized based on their characteristics and the rights they confer. Common types of financial instruments include: 1. Equity Instruments: Represent ownership in a company. Common examples include stocks and shares. 2. Debt Instruments: Represent a loan or an obligation to repay borrowed capital. Common examples include bonds, promissory notes, and certificates of deposit. 3. Derivative Instruments: Derive their value from an underlying asset, index, or rate. Examples include options, futures, and swaps. 4. Money Market Instruments: Short-term, highly liquid debt instruments with maturities usually less than a year. Examples include Treasury bills and commercial paper. 5. Foreign Exchange Instruments: Represent claims on foreign currencies. Examples include currency pairs traded in the forex market. 6. Commodity Instruments: Represent ownership or a claim on physical commodities. Examples include commodity futures contracts. 7. Hybrid Instruments: Combine characteristics of different types of financial instruments. Convertible bonds, for instance, combine features of debt and equity. 8. Real Assets: Represent ownership or claims on physical assets such as real estate or commodities. 9. Cryptocurrencies: Digital or virtual currencies that use cryptography for security. Examples include Bitcoin and Ethereum. FINANCIAL INTERMEDIARY OVERVIEW OF FINANCIAL INSTITUTIONS FIs (commercial banks, credit unions, insurance companies, finance companies, mutual funds) provide the important and essential function of channeling funds, credit and capital from those with a surplus of funds (suppliers of capital/credit) to those who need capital/credit (demanders of capital/credit). Without FIs, funds would have to be channeled by a direct transfer between suppliers (households) and demanders (firms) of credit/capital, Imagine credit markets operating without commercial banks, where individuals lent money directly to borrowers (instead of depositing funds into a bank account) without the bank as an intermediary. Why might that arrangement lead to a sup-optimal amount of credit in the economy? 1. Monitoring costs would be very high for individuals making loans or supplying capital directly to borrowers e.g. companies or other individuals, vs. financial intermediaries and SEC. 2. Financial claims like private loans might be very illiquid, and there might be very high transaction costs for trading the financial claims. 3. Individuals would be exposed to a high level of risk, undiversified loan portfolios. FINANCIAL INTERMEDIARIES Central Bank of Nigeria Commercial Banks Development Banks (e.g. BOI) Savings and Loans Microfinance Banks Finance Companies Pension Fund Managers Real Estate Investment Trusts AGENTS AND BROKERS Issuing Houses Investment Banks. Stock Brokers Stock Market Agents (SMA) INVESTORS AND BORROWERS Stock Owners Bond Owners Loan Borrowers Business State Governments Federal Government PROVIDERS OF FUNDS * Individuals * Corporations * Pension Funds Institutional investors * Insurance Companies, etc *Users of Funds * Companies  * Governments *Intermediaries * Stock broking firms * Issuing houses * Registrars * Trustees * Auditing firms *Regulators * The Securities & Exchange Commission (“SEC”) * The Nigerian Stock Exchange (as a Self-regulatory organization,“SRO”) UNIQUE FUNCTIONS PERFORMED BY FI 1) monitoring costs, 2) liquidity and transaction costs, 3) risk, credit/capital markets would not be very developed using only direct finance. However, using indirect finance through FIs, credit and capital markets develop to a much more advanced level, significantly increasing the volume of credit in the economy. FIs can more effectively and efficiently deal with the potential problems than individuals, 1. FI can act on behalf of a large group of investors/savers, and can monitor users of funds on behalf of borrowers and stockholders efficiently, due to economies of scale. For example, a) banks hire credit analysts to assess creditworthiness and they monitor businesses who borrow money, b) mutual funds and institutional investors can hire financial analysts to do market research and c) investment banks conduct research on companies for clients/fund suppliers in the underwriting process, e.g., an IPO. 2. FIs provide liquidity to credit/capital markets. For example, banks and mutual funds allow depositors/investors to make an unlimited number of small deposits and withdrawals to their accounts, increasing liquidity. Indirect finance through a stock mutual fund is much more liquid than direct finance in individual stocks. 3. FIs increase diversification for savers/investors, e.g. putting money in a bank deposit is an "investment" in a diversified loan portfolio. Diversification through a mutual fund is much easier, more efficient, lower cost than trying to diversify using direct finance in stocks, especially for an average investor. 4. Because of economies of scale, FIs can achieve efficiencies due to their large scale of operations and significantly lower overall transaction costs. For example, spending $100 to buy a private research report on a new company is affordable for a $10B mutual fund, compared to an individual with a $10,000 investment buying the report. 5. FIs provide maturity intermediation. Most depositors want to make short term deposits, but most borrowers want long term loans, e.g. borrowers/homeowners want 30 year mortgages but don't necessarily want to make 30 year bank deposits. Without FIs bearing the risk of maturity mismatch, there might not even be a long term mortgage market. 6. FIs provide denomination intermediation, since some securities are sold in amounts beyond the reach of an average investor, e.g. min. $100,000 negotiable CDs and min. $250,000 commercial paper packages. By investing in a money market mutual fund, these investments become accessible to the average investor. Other Economic Functions FIs Provide to the Economy 7. Commercial banks assist in the transmission of monetary policy, since they are the primary channel and conduit for the implementation of monetary policy. Open market operations by the Fed inject additional bank reserves into the banking system, and that is how new money in the economy is created. 8. Special credit markets in the economy can be effectively served by FIs, e.g. savings and loans and thrifts must specialize in the residential mortgage market, 65% of assets must be mortgage related. Goal: to make home ownership possible and affordable. 9. FIs provide valuable payment services to the economy, in the form of check-clearing and wire transfers, about $3T daily. WHY FINANCIAL INTERMEDIARIES Why intermediation? Definition: Intermediate between providers and users of financial capital Besides banks - pension funds, insurance companies, securities firms (differ in terms of assets. liabilities, matching). But in an Arrow-Debreu “complete markets” world, financing of firms and governments by households occurs via financial markets – no transactions costs, full set of contingent markets, no credit rationing, Pareto optimal allocation and no role for intermediaries Moreover, (Modigliani-Miller) financial structure is irrelevant as households can construct portfolios offsetting actions of intermediaries and intermediaries cannot add value - Corollary - markets are not strong form efficient or banks would not exist. Banks rather assist market efficiency as their information spills over. Functions of intermediaries THE NATURE OF FINANCIAL INTERMEDIATION The Nature of Financial Intermediation The Economics of Financial Intermediation In a world of perfect financial markets there would be no need for financial intermediaries (middlemen) in the process of lending and/or borrowing Costless transactions Securities can be purchased in any denomination Perfect information about the quality of financial instruments Reasons for Financial Intermediation Transaction costs Cost of bringing lender/borrower together Reduced when financial intermediation is used Relevant to smaller lenders/borrowers Portfolio Diversification Spread investments over larger number of securities and reduce risk exposure Option not available to small investors with limited funds Mutual Funds—pooling of funds from many investors and purchase a portfolio of many different securities Reasons for Financial Intermediation CONT’D Gathering of Information Intermediaries are efficient at obtaining information, evaluating credit risks, and are specialists in production of information Asymmetric Information Adverse Selection Moral Hazard Asymmetric Information Buyers/sellers not equally informed about product Can be difficult to determine credit worthiness, mainly for consumers and small businesses Borrower knows more than lender about borrower’s future performance Borrowers may understate risk Asymmetric information is much less of a problem for large businesses—more publicly available information Adverse Selection Related to information about a business before a bank makes a loan Small businesses tend to represent themselves as high quality Banks know some are good and some are bad, how to decide Charge too high an interest, good credit companies look elsewhere—leaves just bad credit risk companies  Charge too low interest, have more losses to bad companies than profits on good companies Market failure—Banker may decide not to lend money to any small businesses Moral Hazard Occurs after the loan is made Taking risks works to owners advantage, prompting owners to make riskier decisions than normal Owner may “hit the jackpot”, however, bank is not better off From owner’s perspective, a moderate loss is same as huge loss—limited liability FINANCIAL INTERMEDIATION The mechanism whereby surplus funds from ultimate savers are matched to deficits incurred by ultimate borrowers The process by which ultimate savers are matched to ultimate borrowers. Saving = Income – Consumption Typically decisions to save are made independently of decisions to invest CHANNELING OF FUNDS In a simple economy we have firms and households Households are the savers and firms are the investors. The mechanism by which households save is by demanding securities from firms The mechanism by which firms invest is by supplying securities to households These securities are claims to the assets of the firm  Simple model of direct finance FUNDS LENT HOUSEHOLDS FIRMS FINANCIAL CLAIMS DIRECT FINANCE Lending and borrowing can occur as a result of direct transacting. But there are costs associated with direct finance Search costs – searching for potential transactors Verification costs – costs in evaluating investment proposals Monitoring costs – costs of monitoring the actions of borrowing Enforcement costs – costs of enforcing contracts EFFICIENT DIRECT FINANCE Some of these costs can be reduced through the organisation of a market. Direct financing requires the existence of an efficient securities market. However not all costs are minimised through a securities market. An additional issue is that the maturity period of finance for the firm is long term. The maturity period of the household is mostly short term. The maturity mismatch of households and firms provide the incentive for the development of intermediated finance.  Indirect (Intermediated) Finance Funds Lent HOUSEHOL Financial Intermediary FIRMS DS Financial Claims WHO ARE BORROWERS AND SAVERS Savers or lenders are households, firms, governments and foreigners Investors or borrowers are households, firms, governments and foreigners. Savers can hold corporate securities (shares), government securities (bonds), currency, bank deposits, foreign currency assets Borrowers can sell shares, sell bonds, issue currency, take bank loans, issue foreign currency liabilities  General Flow of Funds Indirect Finance Financial Intermed iary Lenders – Savers Borrowers – FINAN Spenders 1. Households CIAL 1. Firms 2. Firms DirectMARK Finance ET 2. Government 3. Government 3. Households 4. Foreigners Foreigners FLOW OF FUNDS ANALYSIS S = Saving I = private investment G = government spending T = taxes X = exports M = imports Y=C+I+G+X–M Y=C+S+T 0 = (I – S) + (G – T) + (X – M) FINANCIAL ASSETS H = high powered money = Currency + bank reserves D = Stock of Bank deposits L = Stock of Bank loans Q = Stock of Private securities B = Stock of government bonds  F = Stock of foreign financial assets A superscript ‘d’ represents demand and a superscript ‘s’ represents supply. STOCKS AND FLOWS A stock is measured at a point in time Stock of assets, money, bonds, physical capital measured at 31 December 2007 Flows are measured over a period of time Examples of flows are GDP, Savings, Investment measured quarterly, or annually FINANCIAL INSTRUMENTS IN USE IN THE CAPITAL MARKET What Is a Financial Instrument? Financial instruments are assets that can be traded, or they can also be seen as packages of capital that may be traded. Most types of financial instruments provide efficient flow and transfer of capital all throughout the world's investors. These assets can be cash, a contractual right to deliver or receive cash or another type of financial instrument, or evidence of one's ownership of an entity. KEY TAKEAWAYS A financial instrument is a real or virtual document representing a legal agreement involving any kind of monetary value. Financial instruments may be divided into two types: cash instruments and derivative instruments. Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based. Foreign exchange instruments comprise a third, unique type of financial instrument Understanding Financial Instruments Financial instruments can be real or virtual documents representing a legal agreement involving any kind of monetary value. Equity-based financial instruments represent ownership of an asset. Debt- based financial instruments represent a loan made by an investor to the owner of the asset. Foreign Exchange instruments comprise a third, unique type of financial instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity. International Accounting Standards (IAS) defines financial instruments as "any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity." Types of Financial Instruments Financial instruments may be divided into two types: cash instruments and derivative instruments. Cash Instruments The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable. Cash instruments may also be deposits and loans agreed upon by borrowers and lenders. Derivative Instruments The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices. An equity options contract, for example, is a derivative because it derives its value from the underlying stock. The option gives the right, but not the obligation, to buy or sell the stock at a specified price and by a certain date. As the price of the stock rises and falls, so too does the value of the option although not necessarily by the same percentage. There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a market or process whereby securities–that are not listed on formal exchanges–are priced and traded. Types of Asset Classes of Financial Instruments Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based. Debt-Based Financial Instruments Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs). Exchange-traded derivatives under short-term, debt-based financial instruments can be short-term interest rate futures. OTC derivatives are forward rate agreements. Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives. Equity-Based Financial Instruments Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives. Special Considerations There are no securities under foreign exchange. Cash equivalents come in spot foreign exchange, which is the current prevailing rate. Exchange-traded derivatives under foreign exchange are currency futures. OTC derivatives come in foreign exchange options, outright forwards, and foreign exchange swaps. Derivative A derivative is a securitized contract between two or more parties whose value is dependent upon or derived from one or more underlying assets. Its price is determined by fluctuations in that asset, which can be stocks, bonds, currencies, commodities, or market indexes. Swap A swap is a derivative contract through which two parties exchange financial instruments, such as interest rates, commodities, or foreign exchange. Security A security is a fungible, negotiable financial instrument that represents some type of financial value, usually in the form of a stock, bond, or option. FINANCIAL INSTRUMENTS IN CAPITAL MARKET This could be broadly classified into the following *Equity * Ordinary shares * Preference shares *Debt * Government Bonds (Federal, State and Local Governments) * Industrial Loans/Debenture Stocks & Bonds *Derivatives * Options, rights, swaps * Futures, etc FINANCIAL INSTRUMENTS IN MONEY MARKET Money Market Fund Definition A money market fund is a type of mutual fund that invests in high-quality, short-term debt instruments and cash equivalents. Money Market Instruments. The money market instruments include: (i) Treasury Bills. These are bills issued by the Treasury in order to generate the funds needed for their financial obligations. Monetary policy is also carried out through open- market operations using Treasury Securities. These securities have recently occupied a prominent place in the financial system. (ii) Federal Sponsored Agency Securities. Several government agencies issue non-guaranteed securities in order to generate funds. A typical example of this agency is the Nigerian Bank of Industry (BOI). (iii) Banker’s Acceptances. A banker’s acceptance is a debt instrument created by non- financial business firms and guaranteed by a bank. The market for banker’s acceptances is, however, relatively small in Nigeria. (iv) Negotiable Certificates of Deposits (CDs). A CD is a receipt for a deposit of funds in the bank, which, when presented at maturity, entitles the holder to receive the deposit plus the accrued interest. It represents borrowing by a bank through the issuance of short-term notes. (v) Commercial Paper. This is simply promissory notes issued by large firms with high credit standings. Firms use it to borrow short-term funds on the open market, and hence it provides an alternative to borrowing from a bank. STRUCTURE OF FINANCIAL MARKETS Firm (or individual) obtains funds in the debt market or the equity market A debt instrument (bond or mortgage) pays a fixed income stream over a specified period. The maturity of the debt instrument is short term if less than a year, long term if more than 10 years and intermediate term if in between, Equities (common stock) are claims to shares in the profits and assets of a business. Equities pay periodic sums called dividends. The disadvantage of equity is that the holder is a residual claimant PRIMARY AND SECONDARY MARKETS Primary market is the market for new issues of securities, or initial public offerings (IPOs) Secondary market is where existing securities are traded (NYSE, NASDAQ, LSE, etc) Some IPOs are well known and advertised and attract a lot of attention but many are of unknown enterprises and are underwritten by a known investment bank. Brokers are agents of investors who match buyers and sellers of securities. Dealers link buyers and sellers by buying and selling securities at stated prices. A Market Maker buys/sells at the quoted bid-ask spread with the aim of making a profit on the spread. MONEY AND CAPITAL MARKETS Markets are sometimes distinguished on the basis of maturity of the securities traded. The Money Market is a financial market where short term debt instruments are traded (less than a year) – Commercial paper, Bills etc The Capital Market is where long term debt (longer than one year such as bonds) and equities are traded. The money market is usually more liquid and more traded and so is used by financial institutions to earn income on surplus funds. INTERNATIONAL FINANCIAL MARKETS Foreign bonds are denominated in the currency of the market in which it is sold. Eurobond is bond denominated in a currency other than the currency of the market in which it is sold. Eurocurrencies are foreign currencies deposited in banks outside the home country. Eurodollars are dollars deposited in banks outside the USA Advantages of Financial Intermediaries  They help in lowering the risk of an individual with surplus cash by spreading the ri sk via lending to several people. Also, they thoroughly screen the borrower, thus, lowering the default risk. They help in saving time and cost. Since these intermediaries deal with a large number of customers, they enjoy e conomi es of scale. Since they offer a large number of services, it helps them customize services for their client. For instance, banks can customize the loans for small and long term borrowers or as per their specific needs. Similarly, insurance companies customize plans for all age groups. They accumulate and process information, thus lowering the problem of asymmetric information. Attributes of Financial Instruments. 1. Maturity: time that must elapse before the borrower must repay the debt in full. Maturity is most meaningfully measured relative to the current point in time. When debts are issued, most debts have a well defined maturity that may range from single day to many years. Exemption to this current point in time are (a) Bonds called Consols or perpetuity i.e. infinite maturity and (b) Demand deposit in a bank which are liabilities i.e. due whenever the holder wishes to cash them – no specific maturity 2. Liquidity: financial instrument (assets) must have the capability of being converted to cash/money quickly without loss of value in terms of money. An asset is illiquid to the extent that its conversion into money requires time or entails loss of value either through a decline in its market value or through conversion cost. A debt instrument is more likely to achieve a high degree of liquidity if it possesses two characteristics (1) it is a claim on an issuer with an excellent reputation for meeting its obligations promptly and in full (2) it is of short maturity payable on demand. Most holders consider liquidity to be a desirable characteristic in an asset and are willing to forgo some income to buy some liquidity 3. Safety of the Principal: by safety of the principal we mean freedom from risk that the value of the debt instrument will decline. Safety in relative sense. Instrument that are highly liquid are also highly safe. Risk loss of principal value are of two types namely (1)Risk of default which is the risk that promised payments of interest and repayment of principal will not be met fully and on schedule default risk on debt instruments obviously differ from one issuer to another because they carry different risks hence differences in priority of claim against assets or income or both. (2) Market risk is the risk that the market price of a debt instrument will decline even if there is no risk of default e.eg when interest rates rise because of the inverse relationship between interest rate and price of debt instruments. FINANCIAL INDUSTRY OVERVIEW EVOLUTION AND OVERVIEW OF FINANCIAL INDUSTRY AND THE NIGERIA FINANCIAL SYSTEMS The financial system includes all financial intermediaries that operate in the financial sector in the economy. It is anchored on the belief that economic agents are categorized into surplus and deficit spending units. The surplus spending units are individuals, groups or organizations operating within the economy that have excess funds above their immediate needs. They constitute suppliers of surplus funds to the financial system. The deficit spending units are those that have a shortage of funds and thus require borrowing to fund their operations. They are the users of the excess funds supplied by the surplus spending units in the financial system. The financial system provides an enabling environment for economic growth and development, productive activity, financial intermediation, capital formation and management of the payments system. With intermediation, savers lend to intermediaries, who in turn lend firms and other fund using units. The saver holds claim against the intermediaries, in form of deposits rather than against the firm. These institutions provide a useful service by reducing the cost to individuals, of negotiating transactions, providing information, achieving diversification and attaining liquidity. OVERVIEW OF NIGERIA FINANCIAL SYSTEMS The Nigerian financial system includes financial markets (money and capital markets), financial institutions including the regulatory and supervisory authorities, Development finance institutions (Urban Development Bank, Nigerian Agricultural and Rural Cooperatives bank) and other Finance institutions (Insurance companies, Pension funds, Finance companies, Bureau de change, and Primary Mortgage Institutions), among others. It also offers financial instruments (e.g. treasury bills, treasury certificates, central bank certificates), The structure of the Nigerian Financial System has been through remarkable changes, ranging from their ownership structure, the length and breadth of financial instruments used to the number of institutions established, regulatory and supervisory frameworks as well as the overall macroeconomic environment within which they operate. The Nigerian Financial System also consists of interrelationships among the persons and the bodies that make up the economy. Commercial banks are the most relevant financial institutions in Nigeria to encourage and mobilize savings and also channel savings into productive investment units. THE STRUCTURE AND THE ROLE OF NIGERIA FINANCIAL SYSTEMS The Nigerian financial system consists of the formal sector (bank and non-bank financial institutions) and the informal sector (savings and loan association, local money lenders, etc.). The institutions are regulated by the Central Bank of Nigeria (CBN), Federal Ministry of Finance, Nigeria Deposit Insurance Corporation (NDIC), Securities and Exchange Commission (SEC), the National Insurance Commission (NAICOM), and the Federal Mortgage Bank of Nigeria (FMBN). The informal sector is largely loosely organized without any form of formal regulation. To interpret the financial system and evaluate its performance requires an understanding of its functions in the economy. With reference to the allocation of resources and economic efficiency, the financial system performs three major functions, which are vital to economic growth and development. First, the system provides convenient and efficient payments system without which specialization in production, so vital to productivity improvements would be greatly impeded. Secondly, the financial system pools savings from net surplus units and channels them to productive investment. A sound financial system is critical to economic growth. It enhances economic performance of the players by improving the overall welfare of the people. The financial system provides a platform for financial infrastructure to help allocate resources to individuals/units that are potentially more productive, to invest those resources. The financial system gives room for more efficient transfer of resources/funds. In any economy, problems of inefficient allocation of financial resources and information asymmetry may arise as one financial institution possesses superior information than  the other parties. The financial system provides a balance between those who have funds to invest and those in need of funds, if the problem of information asymmetry is solved. The transfer of funds from surplus units (mainly household) to deficit units (mainly business, government and some households) can take place directly, while direct finance, as the process is called is inconvenient both for ultimate provider of funds and the ultimate user of funds. Describe the financial services industry; Identify types of financial institutions, including banks and insurance companies; Define the investment industry; Explain how economies benefit from the existence of the investment industry; Explain how investors benefit from the existence of the investment industry; Describe types and functions of participants of the investment industry; Describe forces that affect the evolution of the investment industry. ETHICS AND REGULATIONS ETHICS Introduction 1. Presentation of the Subject 2. The State of the "Ethics-Regulation" Question 3. The Evolution of Regulation II. Ethics in the Financial System 1. The Ethical Nature of Economic Decisions 2. The Time Horizon in the Financial System III. Regulation in the Financial System 1. Theoretical Justification for Regulation 2. Relations Between Financial Intermediaries and Regulating Agents IV. The Relationship Between the Ethical and the Regulative Approach V. Forms of Regulation on the Financial Markets 1. Rules of Behaviour 2. Supervision and Regulation 3. Self-regulation VI. Regulation and Risks VII. Conclusions  Learning Objectives 1. Discuss the reasons that investing behavior may be unethical. 2. Identify the key professional responsibilities of investment agents. 3. Describe practices that investment agents should pursue or avoid to fulfill their professional responsibilities. 4. Explain how investment agents are regulated. 5. Debate the role of government oversight in the securities industry. What is Ethics This module focuses on the essential foundations for the investment world. The firm ground on which we build for our clients: trust, reputation, confidence and value — the essentials of a strong and healthy client-focused industry. Ethics in general deals with human behaviour that is acceptable or ‘right’, and that which is not acceptable or ‘wrong’ according to conventional morality. General ethical norms encompass truthfulness, honesty, integrity, respect for others, fairness, and justice. They relate to all aspects of life, including business and finance. Financial ethics is, therefore, a subset of general ethics. Ethics refers to the moral principles, values, and standards of conduct that guide individuals and groups in determining what is right or wrong, good or bad, and virtuous or unethical behavior. Ethics provides a framework for making decisions and actions that are consistent with principles such as honesty, integrity, fairness, respect for others, and responsibility. Ethical considerations influence various aspects of human life, including personal behavior, professional conduct, relationships, and societal interactions. Ethics addresses questions about how individuals should treat one another, how organizations should conduct their business, and what constitutes just and equitable practices in society. Ethical norms are essential for maintaining stability and harmony in social life, where people interact with one another. Recognition of others’ needs and aspirations, fairness, and co-operative efforts to deal with common issues are an example of aspects of social behaviour that contribute to social stability. In the process of social evolution, we have developed not only an instinct to care for ourselves but also a conscience to care for others. However, situations may arise in which the need to care for ourselves runs into conflict with the need to care for others. In such situations, ethical norms are needed to guide our behaviour. As Demsey (1999) puts it: ‘Ethics represents the attempt to resolve the conflict between selfishness and selflessness; between our material needs and our conscience’. Financial markets, perhaps more than most, seem to seduce otherwise good citizens into unethical or even illegal behavior. There are several reasons: 1. Investing is a complex, volatile, and unpredictable process, such that the complexity of the process lowers the probability of getting caught. 2. The stakes are high enough and the probability of getting caught is low enough so that the benefits can easily seem to outweigh the costs. The benefits can even blind participants to the costs of getting caught. 3. The complexity of the situation may allow some initial success, and the unethical investor or broker becomes overconfident, encouraging more unethical behavior. 4. Employers may put their employees under pressure to act in the company’s interests rather than clients’ interests. To counteract these realities there are three forces at work: 1. market forces, 2. professional standards, and 3. legal restrictions. But before these topics are discussed, it is useful to review the differences between ethical and unethical, or professional and unprofessional, behaviors in this context. Ethical frameworks may vary across cultures, societies, and belief systems, but they often share fundamental principles that underpin ethical behavior and moral reasoning. Ethical dilemmas arise when individuals or groups encounter situations where competing ethical principles or values come into conflict, requiring careful consideration and judgment to navigate complex moral choices. Ethics is a dynamic field that evolves over time in response to changing social norms, cultural values, technological advancements, and ethical challenges. Ethical reflection, dialogue, and inquiry are essential for fostering ethical awareness, critical thinking, and responsible decision-making in all aspects of human endeavor. Key concepts and principles within ethics include: 1. Integrity: Upholding honesty and truthfulness in one's actions and interactions, and maintaining consistency between one's words and deeds. 2. Respect: Treating others with dignity, fairness, and consideration, regardless of differences in beliefs, backgrounds, or circumstances. 3. Justice: Ensuring fairness, equality, and impartiality in the distribution of resources, opportunities, and treatment among individuals and groups. 4. Beneficence: Acting in ways that promote the well-being and welfare of others, and striving to maximize positive outcomes and minimize harm. 5. Nonmaleficence: Avoiding actions that cause harm, injury, or suffering to others, and taking measures to prevent or mitigate potential harm. 6. Autonomy: Respecting individuals' right to make their own choices and decisions, and honoring their freedom and self-determination. 7. Accountability: Taking responsibility for one's actions, decisions, and their consequences, and being answerable to oneself and others for ethical conduct. Why Ethics Matters Ethics can be defined as a set of moral principles or rules of conduct that provide guidance for our behavior when it affects others. Widely acknowledged fundamental ethical principles include honesty, fairness, diligence, and care and respect for others. Ethical conduct follows those principles and balances self-interest with both the direct and the indirect consequences of that behavior for other people. Not only does unethical behavior by individuals have serious personal consequences—ranging from job loss and reputational damage to fines and even jail—but unethical conduct from market participants, investment professionals, and those who service investors can damage investor trust and thereby impair the sustainability of the global capital markets as a whole. Unfortunately, there seems to be an unending parade of stories bringing to light accounting frauds and manipulations, Ponzi schemes, insider-trading scandals, and other misdeeds. Not surprisingly, this has led to erosion in public confidence in investment professionals. Empirical evidence from numerous surveys documents the low standing in the eyes of the investing public of banks and financial services firms— the very institutions that are entrusted with the economic well-being and retirement security of society. Governments and regulators have historically tried to combat misconduct in the industry through regulatory reform, with various levels of success. Global capital markets are highly regulated to protect investors and other market participants. However, compliance with regulation alone is insufficient to fully earn investor trust. Individuals and firms must develop a “culture of integrity” that permeates all levels of operations and promotes the ethical principles of stewardship of investor assets and working in the best interests of clients, above and beyond strict compliance with the law. A strong ethical culture that helps honest, ethical people engage in ethical behavior will foster the trust of investors, lead to robust global capital markets, and ultimately benefit society. That is why ethics matters. Society ultimately benefits from efficient markets where capital can freely flow to the most productive or innovative destination. Well-functioning capital markets efficiently match those needing capital with those seeking to invest their assets in revenue-generating ventures. In order for capital markets to be efficient, investors must be able to trust that the markets are fair and transparent and offer them the opportunity to be rewarded for the risk they choose to take. Laws, regulations, and enforcement play a vital role but are insufficient alone to guarantee fair and transparent markets. The markets depend on an ethical foundation to guide participants’ judgment and behavior. A key ingredient for this goal is global capital markets that facilitate the efficient allocation of resources so that the available capital finds its way to places where it most benefits that society. These investments are then used to produce goods and services, to fund innovation and jobs, and to promote improvements in standards of living. Indeed, such a function serves the interests of the society. Efficient capital markets, in turn, provide a host of benefits to those providing the investment capital. Investors are provided the opportunity to transfer and transform risk because the capital markets serve as an information exchange, create investment products, provide liquidity, and limit transaction costs. However, a well-functioning and efficient capital market system is dependent on trust of the participants. If investors believe that capital market participants—investment professionals and firms—cannot be trusted with their financial assets or that the capital markets are unfair such that only insiders can be successful, they will be unlikely to invest or, at the very least, will require a higher risk premium. Decreased investment capital can reduce innovation and job creation and hurt the economy and society as a whole. Reduced trust in capital markets can also result in a less vibrant, if not smaller, investment industry. Ethics for a glob