Finance
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F. Sergiani Maggio 2015
References
focused on analysis
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focused on markets
What is finance?
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From surplus to deficit spending units
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Other functions of the financial environment
• making the system liquid
(i.e.“monetary function”
or production of money).
• managing and hedging
risks
• transmitting the
impulses of monetary
policy
• transmitting funds from
SSU to DSU
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Finance and Real Economy:
wall street vs main street
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Finance deals with investments.
What is an “investment”?
investment is consumption deferred over time
E.g. Let’s assume that you want to buy bonds. In this case you are preferring bonds to
other kind of goods. You are preferring to defer money over time.
Basically, you are “investing” in bonds.
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Financial Claims: how funds are transferred
Firms in deficit (DSU) sign IOUs to surplus spending units that are willing to accept. An IOU is a written promise to pay a
specific sum of money (called the principal) plus a fee for the use of the money (called interest) and to have the use of
the money over a period of time (called maturity of the loan). In the real world, IOUs are called “financial claims”.
They are claims against someone at a future time. They may be called also as “securities” or financial instruments. They
are liabilities for borrowers (DSUs) and assets for lenders (SSUs), which illustrates the two faces of debt.
Total financial liabilities outstanding in the economy must equal total financial assets
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What do we exchange on markets?
equities, bonds, hybrid securities, derivatives ...
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bonds
equities
rights on income:
- priority
- amount
- first
- fixed
- last
- residual
rights on patrimony:
- priority
- amount
- first
- fixed
- last
- residual
Reimburse in case of
liquidation
mandatory
discretional
matureness
fixed
perpetual
The relation between prices, risk and return.
The return of a security is function of the risk associated to that security. The more
variable the security, the higher the risk and the higher the risk the higher the return.
Between price and return there is a direct connection. The price of a security is equal to
the cash flows that the owner of that security will receive. It is the return rate that is
asked from investors to be evaluated in the actualization of future cash flows. The link is
clear and it is an inverse relation: the higher the price, the less the return.
Assuming the case of an equity, with D as the dividend and r as the return, we will have
that:
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I derivati
Un contratto derivato è uno strumento finanziario il cui
valore dipende da, o viene derivato da, un titolo
sottostante.
Molti derivati vengono stipulati per assicurarsi da un rischio legato al mercato finanziario (es. cambio o tasso di
interesse) o per speculare su quel rischio.
Esistono diversi tipi di contratti derivati. I principali sono forwards, futures, options e swaps.
I primi due sono un accordo tra due parti per scambiarsi uno specifico ammontare di un asset ad un determinato
prezzo ad un predeterminato punto del tempo nel futuro. Le principali differenze sono date dai mercati in cui sono
venduti (OTC i primi, regolati i secondi dove è presente una controparte centrale nel futures exchange) e grado di
standardizzazione dei contratti (elevata per i future, meno per i forward).
Una opzione garantisce al compratore il diritto a comprare (option call) o a vendere (option put) uno specifico
ammontare di un asset ad un determinato prezzo per uno specifico periodo di tempo.
Un contratto di swap prevede la possibilità per due parti di scambiarsi pagamenti periodici per un predeterminato
periodo di tempo.
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Players and markets - some definitions
market: the physic and logic place where demand meets
the supply.
market makers: private entities that fix the bid-ask price
broker: he searches the opposite side of its client, earns on
commissions
dealer: he is like a broker that can even assume positions on
markets, buying and selling. He can operate as market
maker
issuing company: sells securities to the subscribers
prime bank: he offers advices to the issuing firm, buys and
sells stocks to the public and to bank consortia.
subscriber: buys and sells stocks (from the issuing firm or
from the bank for the public o private groups).
bid-ask spread:
It is the difference between bid price and ask price
imposed by a dealer. The bid price is the price at which the dealer is willing to
buy a security. The ask price is the price at which the dealer is willing to sell a
security. It may be seen also as the margin of operators or, if we are investors,
as an implicit transaction cost.
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Types of Financial Markets: primary markets
Primary markets: here is where financial claims are initially sold by DSUs and where
IPOs or seasoned issues take place. We tend to separate public placements (like IPOs or
seasoned issues) from private placements (where the deal occurs among few private
players). Generally speaking, people are more likely to purchase a primary financial claim if
they believe they will not hold it forever (stocks) or until its maturity (bonds). Here
securities can be sold only once. All subsequent actions take place in secondary markets.
Most of the times, investment banks handle the marketing of securities, putting borrowers
and lenders together (acting as underwriters).
IPOs, private placements and investment banks
Generally speaking, investment banks (such as BofA,
Goldman Sachs, Credit Suisse etc) act as lead
underwiters in IPOs. They advice the issuing firm and
report to the SEC. Then the price is announced. Most of
the times there are more than one underwriter. IPOs are
commonly underpriced, and its collocation often depends
upon the strength and the willingness of firms.
Private placement are cheaper than IPOs and since the
issuing firm sells shares directly to a small group of
investors (using an investment bank), they must not
adhere to the costly SEC registration rules. Nevertheless,
since they are sold among few investors, they are not
suited for large offerings.
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Secondary markets
Secondary markets: here people exchange “previously” issued financial claims. They provide liquidity for investors
who own primary claims.The NYSE, a well organized secondary market, is an example. Trading here does not affect the
outstanding amount of securities and ownership is simply transferred from one investor to another. There are two
important characteristics of securities to investors: marketability and liquidity.
Marketability is the ease with which a security can be sold and converted into cash. It depends upon the cost of trading
and the search for information. The lower these costs, the greater a security’s marketability. Because secondary
markets make it easier to sell securities, their presence increase a security’s marketability.
Liquidity is the ability to convert an asset into cash quickly without loss of value. In common usage, the two terms are
interchangeable but they are different: liquidity implies ther when a security is sold, its value will be preserved.
Marketability does not carry this implication.
In 2007 the NYSE merged with Euronext, a leading
firm on managing stock exchanges. In 2013, the
NYSE-Euronext merged with ICE, a company that
operates in regulated markets, that now owes 23
regulated exchange all over the world, including
Asia.
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Over the counter markets
OTC markets are also known as dealer markets. It differs
from organized exchanges because it has no central trading
place, and investor can execute transactions by visiting or
telephoning an OTC dealer, or using electronic trading
systems linked to the OTC dealer. Traditional stocks traded
OTC are those issued by small firms which would not
qualify to be listed on a major exchange. Today the situation
has become different, and many OTC stocks are issued by
high-profile firms (especially tech firms like Facebook).
The NASDAQ is an OTC market, born in 1971 to link
brokers and dealers in a computer network. It was more a
price-quotation system, but it evolved in a real electronic
market.
OTC markets are often used for derivatives and risky
transactions, exposing firms to a counterpart risk (see
financial crisis 2008). This is why regulators are discussing
to implement a central clearing house in order to solve the
problem. A clearing house is a third intermediary with the
general purpose of reducing one (or both) party risks (e.g.
evaluating the quality of exchanges, monitoring the credit
worthiness etc).
See also: http://www.economist.com/blogs/freeexchange/2010/04/derivatives
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Money markets and Capital markets
Generally speaking, we tend to separate money markets from capital markets due to the
nature of assets bought and sold.
Money markets: wholesale markets for short-term debt
instruments resembling money itself.
Capital Markets: where “capital goods” (such as real
assets) are financed through long-term financial instruments
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Money market
Money markets are markets in which commercial banks
and other business adjust their liquidity position by
borrowing, lending or investing for short period of time.
FED and BCE conducts monetary policy in the money
markets, and the US treasury uses the to finance its day
to day operations.
In the money markets business, governments and even
individuals borrow or lend funds for short period of time
(1-120 days)
The money market is a collection of markets, each trading
different financial instrument. Here, financial claims have
characteristics very similar to money. In fact, money
market instrument typically have short maturities (90 days
or less), are highly liquid with active secondary market and
have low risk of default.
There is no organized exchange, and central to the activity
of money markets are specialized dealers and brokers.
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The crisis of 2008 - money market and commercial
papers
Large companies often issue their unsecured short term bond notes rather than borrowing from banks. These claims
are called “commercial papers”, often backed by a line of credit from banks in order to let the firm pay off the paper at
maturity (if needed).
Since the maturity is less than 270 days (thus avoiding registration from the SEC) and papers are issued in multiple of
100000 $, small investors can invest only with large MMFs. They are considered almost secure, due to the nature of
issuing firms.
Today, even financial enterprises have begun to issue the so called Asset Backed Commercial Papers, short term notes
issued to raise funds. This kind of engagement from large banks hit the commercial paper market in 2008, as Lehman
Brother collapsed.
Several funds suffered large losses, and this led to a wave of investor redemptions similar to a run on a bank, MMF had
become afraid to commit funds even over short periods and their demand for commercial paper had dried up. The
money market was shocked.
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The LIBOR market - money market under stress
The LIBOR (London Interbank Offered Rate) is the
rate at which large banks in London lend money
among themselves. It is the average of data sent the
British Bankers Association from a pool of large
banks daily. It has become the premier short term
interest rate in European Money Market, and serves
for a wide range of transactions. It is generally
denominated in dollar but can be denominated even
in yen, euros, pounds.
In 2009 the FSA (english surveillance authority) files a
lawsuit against the manipulation of the LIBOR.
Several banks have been investigated, and forced to
pay fines. It has been discovered that they
manipulated the benchmark submitting false data to
the BBA. Even the Euribor (similar benchmark) has
been manipulated, thus affecting the whole money
market.
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So... what is money?
Generally speaking, money is something very complex to understand. It is composed not
only by the monetary base, but also by monetary aggregates (M1,M2,M3) such as
deposits and high funding liquidity assets. The possibility to exchange assets similar to
money leads towards the phenomenon of shadow banking, a collateral-based system,
that needs no public backstop [...] involves money market funding of capital market
borrowing [...] and involves market pricing of specialized, profit-seeking dealers. In other
words, quoting the FSB (2011) “The Shadow Banking System is a system of credit
intermediation that involves entities and activities [fully or partially] outside the regular
banking system”
this is how commercial banks
and other investors perceive
money.
Sweeney, 2012
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The Capital Market
Owners of apartments, office buildings, warehouses and other tangible assets hope to earn a stream of future income
by using their resources to provide services directly to consumers or to other business. These assets are called capital
goods, they are the stock of assets used in production.
Capital markets are markets where capital goods are financed with stock or long-term debt instruments. Compared to
money market, capital market instruments are less marketable, default risk levels vary widely between issuers and have
maturities ranging from 5 to 30 years.
Financial institutions are the connecting link between short term money markets and the longer term capital markets:
they borrow short term and then invest in longer term capital projects either indirectly through business loans or directly
into capital market instruments.
The common instruments exchanged are common stocks such as equities, treasury bonds and notes,
bonds, mortgages,
most stocks are sold in the
secondary market!
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corporate
Mortgages and mortgages backed securities
Mortgages are long-term loans secured by real estate. They are the largest segment in the capital markets in terms
of the amount outstanding. Mortgages by themselves do not have good secondary markets. However, a large
number of mortgages are often pooled together to form new securities called mortgage backed securities, which
have an active secondary market that was hit by financial crisis in 2008.
Specifically, they sell their claim to the cash inflows from the mortgages as those loans are paid off. The mortgage
originator continues to service the loan, collecting principal and interest payments, and passes these payments
along to the purchaser of the mortgage. For this reason, these mortgage-backed securities are called passthroughs. By 2009, about $5.1 trillion of outstanding mortgages were securitized into Freddie or Fannie passthroughs, making this market larger than the $4.0 trillion corporate bond market and comparable to the size of the
$7.1 trillion market in Treasury securities.
The great majority of MBS was issued by Fannie MAE and Freddie Mac, the two government sponsored
enterprises.
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The size of financial players
Main geofinancial
players:
•Hedge funds/Sgr
•Rating Agencies
•Sovereign Wealth
Funds
•Market makers/
investment banks
•Regulators
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