IF440:
Capital Markets and Uncertainty
Ranik Raaen Wahlstrøm
Modules
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Financial Markets and Securities
Risk and Return
Capital Allocation to Risky Assets
Efficient Diversification
Index models
Capital Asset Pricing Model (CAPM)
Arbitrage Pricing Theory (APT)
Efficient Market Hypothesis and Behavioral Finance
Green Finance
Empirical Tests
2
Syllabus
Bodie, Z., Kane, A., & Marcus, A. (2020).
ISE Investments (12th ed.).
McGraw-Hill Education. ISBN 978-1-260-57115-8
Two options:
1. You can buy the physical book at the bookstore or online
2. Alternatively, you can buy the online eBook with 20% discount code
MGH20RA from here: https://www.mheducation.co.uk/iseinvestments-9781260571158-emea-group#configurable-productoptions-title
3
Compulsory assignments
• This course has 2 compulsory assignments
• These shall be submitted in groups of 3-4 students
– If you are not able to find a group, contact the course responsible and
you will be assigned to a group of others also not able to find a group
• The grading is pass/no-pass
• Both assignments must be passed in order to qualify for
the exam
• The final exam count 100% of the grade of this course
4
Student evaluation
See seperate slides in Norwegian:
«Om_studentevaluering_NTNU.pdf»
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Module 1:
Financial Markets and Securities
IF440 - Capital Markets and Uncertainty
Ranik Raaen Wahlstrøm
Outline
• Financial instruments and markets
– Types of financial instruments and markets
– The role of financial markets
– Elementary concepts to perform financial analysis
• Financial crisis
• Systemic risk
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Real Assets
Financial Assets
• Used to produce goods
and services
• Examples: Land,
buildings, machines,
intellectual property
• Examples: Stocks, bonds
• Claims to the income
generated by real assets
or claims on income from
the government
• Do not directly contribute
to the productive capacity
of the economy
• Price ultimately depend
on the performance of the
underlying real asset
Consumption and Investment
• As an individual, one must choose between
consumption now and consumption later
• Consumption later leads to investment, thus one
chooses between consumption and investment
 Investment depends on financial markets
Companies (or other projects) can raise money by issuing:
• Bonds (debt capital)
Examples of
financial instruments
• Shares (equity capital)
11
Financial instruments
We will now discuss the following questions:
• What kinds of securities are available?
• What kind of markets do they trade in?
• What role do these markets play?
• How do particular securities work?
12
Financial instruments
• Financial instruments are standardized financial
contracts
– They must conform to certain laws or exchange listing
requirements
• Standardisation helps to promote liquidity
13
Basic types of financial instruments
• Fixed income instruments (e.g., bonds)
• Equity securities (e.g., company share)
• Derivates (e.g., options and futures)
14
Fixed income instruments
Payments are determined in a contract
• Issuer: the borrower, obliged to pay
• Holder: the lender / investor, right to receive payment
– are promised either
• a fixed stream of income or
• a stream of income determined by a specified formula
– Risk: default / bankruptcy
– Limited upside and limited downside
15
Fixed income instruments
• Example
– Par value (face value): $ 100
– Coupon rate: 3%
– Coupon payment: $3 per year
• payment can also occur semiannually, quarterly or any other interval
– Duration: 20 years
– Par value is usually repaid when duration is out (maturity date)
16
Fixed income instruments
• Short term bonds are often called money market
instruments
• Corporate bonds are issued by corporations
• Government bonds are issued by governments
– Some are considered risk-free
• Fixed income instruments are often "rated" by rating
agencies
– The rate depends on the term (maturity) of the security and the
characteristics of the issuer
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Rating grades
18
Credit risk of High-yield fixed income
• Percentage of default within 5 years after issuance
19
Equity securities
Equities (stocks / shares) are the ownership of a proportion of a
company
• Shares gives the opportunity to vote on annual meetings
• Motivation for investing in shares:
– Dividends (annually, quarterly)
– (Expected) capital gains
•
•
•
•
Limited liability: equity holders have limited downside
Unlimited upside
Risk: neither dividends nor capital gains are certain
Residual claim: stockholders last in line for receiving funds
– Especially relevant in case of liquidation / bankruptcy
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Historical returns
21
Derivatives (contingent claims)
• Value depends on the performance of another financial
asset, called "the underlying asset"
– That is, value is derived from the value of other assets
– Examples of underlying assets: stocks, bonds, commodities
– Theoretically, an infinite number of derivatives (in type and in
number) can be created.
• Futures
– Provide linear payoffs
• Options
– Provide non-linear payoff
22
Futures: Linear payoff
• Calls for delivery of an asset (or cash value) at a
specified delivery or maturity date for an agreed-upon
price, called the futures price, to be paid at contract
maturity
– Long position held by the trader who commits to purchasing the
asset on the delivery date
– Short position held by trader who commits to delivering the asset
at contract maturity
– The long/short position’s profit is the other position’s gain
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Options: Non-linear payoff
• The owner have the right, but not the obligation, to buy
(call option) or sell (put option) an asset for a specified
price on or before a specified expiration date
– The price is called the exercise or strike price
– The premium is the price of the option itself
– Non-linear payoff: Options are exercised only when it is
profitable
24
Other Types of Financial assets
• Currency
– $2 trillion of currency traded each day in London alone
• Commodities
– For example, corn, wheat, natural gas
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Financial Markets
• Financial assets are traded on financial markets
• Trading can either take place on formal exchanges:
– E.g.: NYSE, LSE, Xetra, CME, Eurex, OSE
– Information is usually easier to obtain about prices and
transactions on exchange traded markets than on OTC ones
• Or are privately done:
– Over-the-counter (OTC) markets
– Currency markets, money markets, interest rate swaps, several
bond markets are mainly OTC
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Example of listing of stock
27
Example of listing of stock
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Stock Market Indexes
• Computed from the prices of selected stocks
• Typically used to describe a market, or for comparison
with specific investments
29
Stock Market Indexes
Example: OBX stock exchange index as of June 2021:
The OBX index consists
of the 25 most liquid
shares on the Oslo Stock
Exchange, ranked after
six months' turnover.
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Stock Market Indexes
• Price-weighted average
– Index corresponds to holding one share of each asset in the
relevant market
• Market-value-weighted Index
– Weight of each stock correspond to the proportional to its market
value of outstanding equity
• Equally weighted indexes
– Places an equal weight on each return
– Do not correspond to buy-and-hold strategies
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The markets' role in the economy
1. The informational role
– Prices of financial assets reflect the investors’ expectations of
the current performance and future prospects of the underlying
real assets
– Better performance and prospects result in higher prices
– Higher prices makes it easier for companies to rise capital
– In sum: Allocation of capital to those firms that currently appear
to have the best performance and prospects
• Markets do often allocate capital to bad prospects, as no one know
the future for certain
• However, history have shown that markets allocate better than
alternatives
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The markets' role in the economy
2. Consumption timing
–
–
Use securities to transfer consumption to the future
For example, invest savings in high-earning periods in life, for
providing funds in low-earning periods in life
3. Allocation of risk
– Investors can select securities consistent with their tastes for risk
• Stocks have higher risk and higher return
• Bonds have lower risk and lower return
• Derivates allow to remove all risk of price
33
The markets' role in the economy
4. Separation of Ownership and Management
– The stock holders are the firm’s owners
– Stock holders elect a board of directors, which again hires and
supervises the management
• Management oversee the day-to-day operations
• Board of directors supervise the management regularly
• Stock holders meet for decisions few times each year
– Agency problems arise when managers start pursuing their
own interests instead of maximizing firm's value
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Agency problems and the markets
Mechanisms to mitigate potential agency problems:
A. Managements' compensation plans in stock or stock options tie
the income of managers to the success of the firm and the value
added for shareholders
B. Monitoring by the board of directors
– Boards of directors forcing out underperforming management
C. Close monitoring by large investors and financial analysts
D. Underperforming companies are subject to hostile takeovers
i.
ii.
iii.
Funds or competitors buy a large proportion of shares of a badly managed firm
at a low price
Change management, resulting in better performance
Make profit from the rise in share price
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The Investment Process
• Portfolio: Collection of investment assets
• Rebalancing the portfolio:
– Selling existing assets and buying new
– Expanding/decreasing the portfolio (deposits/withdraws)
• Asset allocation
– Choice among broad asset classes (for example, stocks, bonds,
real estate, etc.)
• Security selection
– Choice of securities within each asset class
36
The Investment Process
• Security analysis involves the valuation of particular
securities that might be included in the portfolio
• “Top-down” approach
– Starts with asset allocation, followed by security selection within
asset classes
• “Bottom-up” approach
– Investment based on attractively priced securities without as
much concern for asset allocation
– Danger of less diversification
37
Markets Are Competitive
• Financial markets are highly competitive
– Thousands of analysts search for good investments
• Risk-return trade-off
– For any investment, there is a risk because there is always an
uncertainty that the future asset price will not be as expected
– Investors do not like risks
– Therefore, higher-risk assets are priced to offer higher expected
returns than lower-risk assets
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Markets Are Competitive
• Efficient market hypothesis
– The prices of securities fully reflect available information
– If this were true, there would exist neither underpriced nor
overpriced securities
– Will be discussed more later in this course (Module 8)
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Passive vs. active investment
• Passive management
– Highly diversified portfolio
– No attempt to improve investment performance by identifying
mispriced securities
• Active management
– Focus on improving performance by finding mispriced securities
or by timing the performance of broad asset classes
– Costlier than passive management
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The Players
1. Firms
– Net demanders of capital from investors
– Capital is used for paying for investments in real assets
– Income generated by real assets provides for return to investors
2. Households / investors
– Purchase securities issued by firms that need to raise funds
3. Governments
– Can function as borrowers or lenders, depending on the
relationship between tax revenue and government expenditures
– Lending by issuing debt securities
41
The Players
• Direct transactions between households and
firms/governments is not efficient
• Financial intermediaries bring the suppliers of capital
together with the demanders of capital. Examples:
– Pension funds
– Mutual funds
• issue their own securities for raising funds for investing
– Hedge funds (typically more complex strategies than mutual funds)
– Banks
• For example, lend customers’ deposits to other customers
– Insurance companies
42
The Players
New issues of securities are offered to the public in the
primary market
Investors trade previously issued securities amongst
themselves in the secondary market
Investment bankers specialize in the sale of new
securities to the public, typically by underwriting the issue
– Advise the issuing corporation on appropriate price, interest rates,
etc.
43
The Players
Venture capital (VC) refers to money invested to finance a
new, not yet publicly traded firm
• VC investors commonly take an active role in the management of a
start-up firm
Private equity refers to investments in companies whose
shares are not publicly traded in a stock market
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Financial Risk and Crisis
OptionSellers.com
• James Cordier - Full apology video (start at 7:25):
https://www.youtube.com/watch?v=LI395YShGRQ
• On 15 November 2018, OptionSellers.com emailed its
investors with a message entitled ''Catastrophic Loss
Event‘’ (www.optionsellerslawsuits.com/what-happened)
• Not only have OptionSellers.com lost their investors'
money (over $150 million), but those same investors
would also owe more money to a third party for margin
calls (over $35 million)
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OptionSellers.com
• OptionSellers.com lost their investors' money
because of a ''short call position in natural gas‘’
that ''overwhelmed all risk measures in place''
US Natural Gas 1 year, weekly bar plot
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OptionSellers.com
US Natural Gas >10 years, weekly closing price
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Lessons learned
• Can you really be sure of the future movements of
financial assets based on the movements in the past?
• What is your time horizon for ''the past''?
• Hedge to reduce risk
– Options are said to be naked when they're unhedged
• What about the future? Build portfolios to consider all
eventualities, also those not taken place in the past
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The Financial Crisis of 2007-2008
• A result of
– high risk and complex financial products few understood
– agency problems
– the failure of
• regulators
• credit rating agencies
• the market itself
51
Changes in Housing Finance
Old Way
• Mortgage loans came from
a local lender, such as a
neighborhood savings bank
or credit union
• Banks would have as its
major asset a portfolio of
these long-term home loans
• Bank’s main liability would
be accounts of its
depositors
New Way
• Securitization is the
pooling of loans for various
purposes into standardized
securities backed by those
loans, which can then be
traded like any other
security
• Fannie Mae and Freddie
Mac became the
behemoths of the mortgage
market
Changes in Housing Finance
From 1970s: only low risk
mortgages were pooled
almost entirely through
Freddie Mac and Fannie
Mae
From 2000s: Securitization
by private firms of
nonconforming “subprime”
loans with higher default risk
– Little verification of
borrower’s ability to repay
– Mortgage brokers and
agencies had little incentive
to perform due diligence
since the loans was sold to
investors
– Adjustable-rate mortgages:
low initial rate, which later
rose
Mortgage Derivatives
• Collateralized debt obligations (CDOs)
– Bundling of loans
– Prioritization of claims on loan repayments by dividing the pool
into senior versus junior tranches
• Senior tranches – first claim on repayments from the entire pool
• Junior tranches – paid only after the senior tranches had been fully
– Ratings underestimated credit risk
• If junior tranches were 30%, it meant that 30% of loans had to
default if senior tranches would be affected
• 30% default seemed highly unlikely  senior tranches rated AAA
54
Why Was Credit Risk Underestimated?
• Default probabilities had been estimated using historical data from
both an unrepresentative period of time and a very different
borrower pool
• Cross-regional diversification did not reduce risk as much as
anticipated
• Agency problems with rating agencies
– Loan brokers: paid for giving loan but no risk if default
– Rating agencies: paid by the issuer of CDOs, not the buyer
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Credit Default Swap (CDS)
• A CDS is an insurance contract against the default of
one of more borrowers
– Purchaser of the swap pays an annual premium for protection
from credit risk
– Investors bought CDSs to insure safety against subprime loans
– Some swap issuers did not have enough capital to back their
CDSs
• For example, AIG alone sold more than $400 billion of CDS
contracts on subprime mortgages
56
Rise of Systemic Risk
• Sources of fragility in 2007
– Many highly leveraged, large banks were relying primarily on
short-term loans for funding
– Widespread investor reliance on CDOs
• Systemic risk is the risk of breakdown in the financial
system, particularly due to spillover effects from one
market into others
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• Fall 2007
– Housing price declines were widespread
– Stock market entered its own free fall
– Many investment banks began to suffer
58
• Crisis peaked in September 2008
– Fannie Mae and Freddie Mac put into conservatorship
– Lehman bankruptcy and AIG bailout
– US Treasury spent hundreds of billions of tax-payers
money to give loans and buy securities
– Banks feared losses on all types of loans, so they were
reluctant to lend  Businesses that relied on loans
bankrupted or scaled down  unemployment rose
59
Crisis became global
EU Unemployment Rate
• Global economic downturn
(Great Recession of 2008-2012)
• European debt crisis
– Greece was hardest hit as it had a
lot of government debt
Spain Unemployment Rate
• Governments had to use taxpayers’ money to bail out banks
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The Terra Scandal
• Among the investors, the Norwegian municipalities:
– Rana, Narvik, Hemnes, Hattfjelldal, Vik, Bremanger, Haugesund
and Kvinesdal
• Terra Securities recommended them to take loans in
future power revenues to invest in structured credit
products, like Mortgage-backed securities
– Total NOK 4,000,000,000 was invested, 88.7% loan.
61
Reforms
• USA: Dodd-Frank Wall Street Reform and Consumer
Protection Act passed in 2010
• Global: BASEL III
– Regulatory framework on bank capital, market liquidity risk, and
stress testing
– Closer supervision of credit rating agencies
• Stress testing: not only for likely events, but also extreme
events that previously have or have not happened (e.g.,
''Black Swans'')
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Movies
Recommended movies about
the financial crisis of 2007-2008
• «The Big Short», 2015
• «Margin Call», 2011
• Note: these movies are not readings in this course
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