Week 3 Lecture - Elements of the Financial System PDF

Week 3 Elements of the financial system BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Explain what financial instruments are, how they are used, and how they are valued. 2. Discuss the role and s...

Week 3 Elements of the financial system BANK2011 Banking and the Financial System The University of Sydney Page 1  Learning Objectives 1. Explain what financial instruments are, how they are used, and how they are valued. 2. Discuss the role and structure of financial markets and identify the characteristics of a well-run financial market. 3. Describe the role of financial institutions and structure of the financial industry. The University of Sydney Page 2  Introduction – Direct Finance: Borrowers sell securities directly to lenders in the financial markets. – Direct finance provides financing for governments and corporations. – Indirect Finance: An institution stands between lender and borrower. – We get a loan from a bank or finance company to buy a car. – Asset: Something of value that you own. – Liability: Something you owe. The University of Sydney Page 3  Introduction – Financial development is linked to economic growth. – The role of the financial system is to facilitate production, employment, and consumption. – Resources are funnelled through the system so resources flow to their most efficient uses. The University of Sydney Page 4  Introduction We will survey the financial system in three steps: 1. Financial instruments or securities – Stocks, bonds, loans and insurance. – What is their role in our economy? 2. Financial Markets – New York Stock Exchange, Nasdaq. – Where investors trade financial instruments. 3. Financial institutions – What they are and what they do. The University of Sydney Page 5  Figure 3.1: Funds Flowing through the Financial System The University of Sydney Page 6  Lessons from the Crisis: Leverage – The use of borrowing to finance part of an investment is called leverage. – Leverage played a key role in the financial crisis of 2007-2009. – The more leverage, the greater the risk that an adverse surprise will lead to bankruptcy. – Financial institutions are much more highly leveraged than households or firms. – During the crisis, some important financial firms leveraged more than 30 times their net worth. – Such high leverage meant that these firms would be vulnerable even to a minor decline in the value of their assets. The University of Sydney Page 7  Lessons from the Crisis: Leverage – When losses are experienced, firms try to deleverage to raise net worth. – As many institutions deleveraged, prices fell, losses increased, and net worth fell. – This “paradox of leverage” reinforces the destabilising liquidity spiral. – Both spirals fed the cycle of falling prices and widespread deleveraging - the hallmark of the financial crisis of 2007-2009. – The financial system steadied only after massive government interventions in response to the plunge of many asset prices. The University of Sydney Page 8  Financial Instruments Financial Instruments: The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under specified conditions. – The enforceability of the obligation is important. – Financial instruments obligate one party (person, company, or government) to transfer something to another party. – Financial instruments specify payment will be made at some future date. – Financial instruments specify conditions under which a payment will be made. The University of Sydney Page 9  Uses of Financial Instruments – Three functions: – Financial instruments act as a means of payment (like money). Employees take stock options as payment for working. – Financial instruments act as stores of value (like money). Financial instruments can be used to transfer purchasing power into the future. – Financial instruments allow for the transfer of risk (unlike money). Futures and insurance contracts allows one person to transfer risk to another. The University of Sydney Page 10  Characteristics of Financial Instruments – These contracts can be very complex. – This complexity is costly, and people do not want to bear these costs. – Standardisation of financial instruments overcomes potential costs of complexity. – Financial instruments also communicate information, summarising certain details about the issuer. The University of Sydney Page 11  Characteristics of Financial Instruments – Mechanisms exist to reduce the cost of monitoring the behaviour of counterparties. – A counterparty is the person or institution on the other side of the contract. – The solution to the high cost of obtaining information is to standardise both the instrument and the information about the issuer. – Financial instruments are designed to handle the problem of asymmetric information. – Borrowers have some information they don’t disclose to lenders. The University of Sydney Page 12  Underlying Versus Derivative Instruments – Underlying instruments are used by savers/lenders to transfer resources directly to investors/borrowers. – This improves the efficient allocation of resources. Examples: stocks and bonds – Derivative instruments are those where their value and payoffs are “derived” from the behaviour of the underlying instruments. – Examples are futures, options, and swaps. – The primary use is to shift risk among investors. The University of Sydney Page 13  A Primer for Valuing Financial Instruments Four fundamental characteristics influence the value of a financial instrument: 1. Size of the payment: – Payments that are larger are more valuable. 2. Timing of payment: – Payments that are made sooner are more valuable. 3. Likelihood that payment is made: – Payments that are more likely to be made are more valuable. 4. Conditions under which payment is made: – Payments that are made when we need them most are more valuable. The University of Sydney Page 14  Financial Instruments Used Primarily as Stores of Value 1. Bank loans – Borrower obtains resources from a lender to be repaid in the future. 2. Bonds – A form of loan issued by a corporation or government. – Can be bought and sold in financial markets. 3. Home mortgages – Home buyers usually need to borrow using the home as collateral for the loan. A specific asset the borrower pledges to protect the lender’s interests. The University of Sydney Page 15  Financial Instruments Used Primarily as Stores of Value 4. Stocks – The holder owns a small piece of the firm and is entitled to part of its profits. – Firms sell stocks to raise money. – Buyers of stocks use them primarily as stores of wealth. 5. Asset-backed securities – Asset-backed securities are shares in the returns or payments arising from specific assets, such as home mortgages, or credit card debt. – Mortgage-backed securities bundle a large number of mortgages together into a pool in which shares are sold. Securities backed by sub-prime mortgages played an important role in the financial crisis of 2007-2009. The University of Sydney Page 16  Financial Instruments Used Primarily to Transfer Risk 1. Insurance contracts. – Primary purpose is to assure that payments will be made under particular, and often rare, circumstances. 2. Futures contracts. – An agreement between two parties to exchange a fixed quantity of a commodity or an asset at a fixed price on a set future date. – A price is always specified. – This is a type of derivative instrument. The University of Sydney Page 17  Financial Instruments Used Primarily to Transfer Risk 3. Options – Derivative instruments whose prices are based on the value of an underlying asset. – Give the holder the right, but not the obligation, to buy or sell a fixed quantity of the asset at a pre-determined price on either a specific date or at any time during a specified period. 4. Swaps – Agreements to exchange two specific cash flows at certain times in the future. – Come in many varieties, reflecting differences in maturity, payment frequency, and underlying cash flows. The University of Sydney Page 18  Financial Markets – Financial markets are places where financial instruments are bought and sold. – These markets are the economy’s central nervous system. – These markets enable both firms and individuals to find financing for their activities. – These markets promote economic efficiency. The University of Sydney Page 19  The Role of Financial Markets 1. Market liquidity: – Ensure owners of financial instruments can buy and sell them cheaply and easily. – Keeps transactions costs low. 2. Information: – Pool and communicate information about issuers of financial instruments. 3. Risk sharing: – Provide individuals a place to buy and sell risks. The University of Sydney Page 20  The Structure of Financial Markets 1. Distinguish between primary or secondary markets 2. Categorise by the way they trade 3. Group based on the type of instrument they trade The University of Sydney Page 21  Primary versus Secondary Markets – A primary financial market is one in which a borrower obtains funds from a lender by selling newly issued securities. – Secondary financial markets are those where people can buy and sell existing securities. The University of Sydney Page 22  Secondary-Market Trading in Stocks – Historically, there were: – Centralised exchanges – dealers meet in a central, physical location to trade stocks. – Over-the-counter markets (OTC’s) – decentralised markets where dealers stand ready to buy and sell securities electronically. – More recently, there are electronic communication networks (ECN’s): – Electronic system bringing buyers and sellers together without the use of a broker or dealer. The University of Sydney Page 23  Secondary-Market Trading in Stocks – Pace of structural change has accelerated dramatically. 1. Ongoing technological advances in computing and communications Lowered the importance of a physical location of an exchange. 2. Increased globalisation Encouraged more cross-border mergers of exchanges. The University of Sydney Page 24  Secondary-Market Trading in Stocks Decentralised electronic exchanges have benefits – Customers can see their orders – Orders happen quickly – Can trade 24 hours a day – Low cost – Reduces operational risk, like when the NYSE was inaccessible for days after 9-11. The University of Sydney Page 25  Secondary-Market Trading in Stocks – But decentralised electronic exchanges also have risks. – Electronic operations have proven prone to errors that threaten the existence of brokers. – New trading patterns have arisen that render the system fragile. Trading algorithm is a rule-based program for automatically executing hundreds or thousands of trades. High frequency traders (HFTs) can purchase or sell thousands of stocks in seconds. – We also see that efforts to speed up electronic trading drain resources from other uses. – Could diminish the willingness of market makers to provide liquidity. The University of Sydney Page 26  Debt and Equity versus Derivative Markets – Used to distinguish between markets where debt and equity are traded and those where derivative instruments are traded. – Debt markets are markets for loans, mortgages, and bonds. – Equity markets are the markets for stocks. – Derivative markets are the markets where investors trade instruments like futures, options, and swaps. The University of Sydney Page 27  Debt and Equity versus Derivative Markets – In debt and equity markets, actual claims are bought and sold for immediate cash payments. – In derivative markets, investors make agreements that are settled later. – Debt instruments categorised by the loan’s maturity – Debt instruments that are completely repaid in less than a year (from their original maturity date) are traded in money markets. – Those with a maturity of more than a year are traded in bond markets. The University of Sydney Page 28  Characteristics of a Well-Run Financial Market – Essential characteristics of a well-run financial market: – Must be designed to keep transaction costs low. – Information the market pools and communicates must be accurate and widely available. – Borrowers’ promises to pay lenders must be credible. Lenders must be able to enforce their right to receive repayment quickly and at low cost. The University of Sydney Page 29  Financial Institutions – Financial institutions are firms that provide access to the financial markets, both – to savers who wish to purchase financial instruments directly and – to borrowers who want to issue them. – Because financial institutions sit between savers and borrowers, they are also known as financial intermediaries. – Examples: banks, insurance companies, securities firms, and pension funds. The University of Sydney Page 30  The Role of Financial Institutions – To reduce transaction costs by specialising in the issuance of standardised securities. – To reduce the information costs of screening and monitoring borrowers. – They curb information asymmetries, helping resources flow to their most productive uses. – To give savers ready access to their funds. The University of Sydney Page 31  The Structure of the Financial Industry – We can divide intermediaries into two broad categories: – Depository institutions, Take deposits and make loans They are what most people think of as banks. – Non-depository institutions. Include insurance companies, securities firms, asset management firms, hedge funds, private equity or venture capital firms, finance companies, and pension funds. The University of Sydney Page 32  The Structure of the Financial Industry 1. Depository institutions take deposits and make loans. 2. Insurance companies accept premiums, which they invest in securities and real estate, in return for promising compensation to policyholders should certain events occur. 3. Pension funds invest individual and company contributions in stocks, bonds, and real estate in order to provide payments to retired workers. The University of Sydney Page 33  The Structure of the Financial Industry 4. Securities firms include brokers, investment banks, underwriters, asset management firms, private equity firms, and venture capital firms. – Brokers and investment banks issue stocks and bonds to corporate customers, trade them, and advise customers. – Asset management firms pool the resources of individuals and companies and invest them in portfolios of bonds, stocks, and real estate. – Hedge funds do the same for small groups of wealthy investors. – Private equity and venture capital firms also serve wealthy investors by acquiring controlling stakes in a few firms and managing them actively. 5. Finance companies raise funds directly in the financial markets in order to make loans to individuals and firms. 6. Government-sponsored enterprises (GSEs) are federal credit agencies that provide loans directly for farmers and home mortgagors. The University of Sydney Page 34  Figure 3.2: Flow of Funds through Financial Institutions The University of Sydney Page 35  Homework problems – CS chapter 3 – Problems 3, 10, 11, 13, 15, 17, 18, 21 – Data exploration problems 3-5 The University of Sydney Page 36