FINANCIAL MARKETS Financial markets are markets where funds are transferred from people that have an excess of available funds to people who have a need of them. Financial markets are crucial to promote greater economic efficiency because they move funds to people that have a productive use of them. In the financial markets are traded activities, which are financial instruments, that affect personal wealth and the business cycle. Bonds: bonds are debt securities in which the issuer promises to make payments periodically for a specified period of time. Corporations use bonds to raise funds to finance their activities (a more efficient way to allocate money for the system). The cost of borrowing money is the interest rate, and there is an inverse relationship between bond prices and interest rates. Since different interest rates have a tendency to move in unison, it is common for economists to lump interest rates together, but it is important to differentiate between: - Short and long term interest rates, which in other words is studying the term structure of interest rates. Risk free and risky assets, interest rates move in reaction to inflation and default risk. The more an asset is risky, the higher its interest rate will be. FINANCIAL INSTITUTIONS Financial intermediaries: they are institutions that borrow funds from people that have saved them and make loans to people or corporations that need funds. They can be divided into 2 categories: - Banks, they accept deposits and make loans Other financial institutions, such as insurance companies, pension funds, mutual funds, finance companies and investment companies. These intermediaries, especially banks, have a crucial role to the well-functioning of financial markets because they: - Make a selection to whom extend credit Write complicated contracts with plenty of information when they extend a loan Are heavily regulated Promote financial innovation, that allows to get a more efficient financial system. MONEY AND MONETARY THEORY Money is anything that is generally accepted as a means of payment for goods, services and debt repayment. It is linked to changes in economic and financial variables as in the short-medium term, it has an important role in generating the business cycle, while in the long run it has a role in affecting the aggregate price level (inflation) but has no role in the long run for economic growth. On the other hand, monetary theory ties changes in the money supply related to monetary policy (management of the amount of money and the interest rates level by the Central Bank) to changes in aggregate economic activity (output or GDP, and employment), and changes in the price level (inflation). The relation between money growth and interest rates has been less clear since 1980. CREDIT, OUTPUT AND FINANCIAL MARKETS OVER THE FINANCIAL CYCLE There is a positive correlation between credit and property and asset prices over the medium run. With a rapid increase in credit, there is typically an increase in property and asset prices, which in turn increase collateral values and consequently the amount of credit the private sector can obtain, up to a point in which this process goes into reverse. This phenomenon produces a financial cycle. The reason beyond that is that if financial intermediates and financial markets increase their credit portfolio, firms and households are going to accumulate a strong amount of debt, with a subsequent heavy debt service (i.e. interest payments), which have a large negative effect in growth. In fact, if the interest rate was to go up, the interest payments would go up too and there would be a higher risk of default for companies and households, that could potentially bring a recession. These financial cycles could build up even alongside low and stable, or even falling, inflation. FINANCIAL CRISES Financial crises are characterized by: - Strong declines in asset prices, whether they are stocks, bonds or real estate Widespread failures of firms, both of the financial sector and not Heavy business cycle downturns, recessions induced by financial crises, which are much worse than normal ones. In the last few years, thanks to globalization, financial crises have transmitted from the market in which they originated to the whole world, as happened in 2008. MONETARY AND FISCAL POLICY Any government deficit must be financed by borrowing or printing money. (G-T) = ΔB + ππ΄π , where G is the public expense, T is the government income (taxes), ΔB is the delta of bonds and π₯π π is the delta of money supply. The broader the government deficit is the higher the rate of money growth will be, that will create a higher inflation rate that, in order to be slowed, will cause a higher level of nominal interest rates. This shows that there is an association between monetary and fiscal policy. REAL AND NOMINAL GDP When calculating the total value of final goods and services are used current prices, the GDP obtained is the nominal GDP. On the other hand, the real GDP indicates that values are measured in terms of fixed prices (prices prevailing in the base year). The real GDP is a more reliable measure, and it uses as a base year 2009. AGGREGATE PRICE LEVEL It is a measure of average prices in the economy and there are 3 measures of it: - GDP deflator Personal consumption expenditure (PCE) deflator Consumer price index (CPI). This is the most frequently used measure for the aggregate price level, also known as inflation. CPI: the CPI is measured by pricing a basket of goods and services and if over time, the cost of this basket rises, the percentage rate of growth corresponds to the inflation rate. CPI, PCE, and GDP deflator can be used to deflate a nominal magnitude into a real magnitude (for example the GDP) by dividing the nominal magnitude by the price index. FROM SUBSISTENCE ECONOMY TO BARTER TRADE TO A MONETARY ECONOMY Subsistence economy: in a subsistence economy everyone consumes whatever they produce. For example, a farmer would consume berries and a fisherman fish. There is no trade. This type of economy is not efficient, because it would be much better if there was a trade between the fisherman and the farmer so that they could specialize in the production of one good and trading it for a determined amount of the other good. If this were to happen, we would get to the barter trade because they are swapping a determined amount of berries for a determined amount of fish without any money. Nowadays the exchanges that people wish to carry out are so complicated that using the barter trade would be very difficult. - Firstly, are involved large numbers of people and goods and for this reason the double coincidende of wants in a barter economy is a problem. Secondly, the timing of the exchanges might not be coincident. In modern economies, some wish to borrow and other wish to hold claims, or IOUs (I owe you), to be repaid by someone else at a later point in time. For these and other many reasons, in today’s economy we use money as: - A medium of exchange, it is something you hold to trade it later on for something else. This implies trust, trust that money will retain its real value in a reasonably predictable way over time. If used as a medium of exchange, money solves the problem of the double coincidence of wants typical of the barter economy, reducing transaction costs and promoting efficiency by allowing exchanges that wouldn’t happen in a barter economy. - A store of value, a special form of IOU and a financial asset. To be more precise, money is the most liquid financial asset, since it does not need to be traded and can be directly used as a medium of exchange without any cost of transaction (brokerage fee when you sell a house). This is the main reason why it is used as a store of value: its degree of liquidity. Liquidity measures the relative ease and speed with wich an asset can be converted into a medium of exchange. Since it is the most liquid asset, people are willing to hold it (i.e. keeping money in your bank account) even if it is not the most attractive store of value in terms of remuneration. When there are high inflationary periods though, the real value of money can drop significantly in a short amount of time (periods of hyperinflation). When this happens, money is no more a store of value and so people restart doing barter trades. This happened in the ‘80s in some South American countries, where the local currency lost so much of its real value even in days that it was no longer utilized. People started again doing barter trades or using the US dollar as a medium of exchange. - A unit of account, as it is used to measure value in the economic system. It’s useful also for people because you can easily compare different goods and services by their prices to measure their value. Since comparison is much easier, money reduces transaction costs. Obviously, the benefits of using money as a unit of account are larger as the economy becomes more complex. These three functions are closely linked to each other because the more a commodity is used as a medium of exchange, the stronger are the incentives to use it as a unit of account and store of value. So, if a type of money gets used broadly in a society as medium of exchange, it will be used as a unit of account to compare different goods and services and a store of value throughout the time. Definition of money: money is the stock of assets that can be readily used to make transactions. This is the definition of money as medium of exchange. Once a commodity is chosen to be money, this choice is strengthened by network externalities, that means that the more people utilize and consider as a medium of exchange, a store of value, and a unit of account that precise commodity money, the more its utility will be for a user. So, a network exists when a product’s value to the user increases as the number of users grows. Each new user derives private benefits, but also external benefits, the network externalities, on existing users. The same logic applies to money. Since the creation of modern central banks, the definition of money and its 3 functions have been easily identifiable and associated to the object through which value was transferred during a transaction, namely, physical banknotes issued by the central bank. Banknotes are denominated in the unit of account and its ability to serve as a store of value is inherited from the stability of the unit of account. If the central bank maintains a low and stable inflation, banknotes will have also the function of store of value. In a primitive society, money was represented by either a physical object or a commodity (stone, salt, pepper, silver, gold…) that had an intrinsic value, such as gold and silver. A commodity money must meet several criteria: - be easily standardized, it must be simple to ascertain its value be widely accepted, it reduces almost to nothing the transaction costs be divisible, in order to be used in small-value transactions be easy to carry, reducing almost to 0 transactions costs not deteriorate quickly/not perishable, since it is a store of value, it cannot deteriorate over time and also it must last long enough for people to use it several times. Using commodities such as silver or gold helped in primitive economies to build trust, because people could exchange them for other goods if they were to reinstate a barter economy. But since these commodities have other uses, there was an opportunity cost in using them as money. For this reason, nowadays we use banknotes or coins as commodity money that have a very low opporutnity cost and in recent years we even use virtual money (bank deposits), or someone could even use cryptos, even if they’re not recognised currencies by central banks. The holder of a cash unit, is automatically the owner of its corresponding value, meaning that the ownership rights to the cash units are always clearly defined without anyone having to keep records (this is only for money as a physical object). Broader definition of money: money is anything that is generally accepted as payment for goods or services or in the repayment of debts. With this definition we can also consider bank deposits as virtual money. As its name might suggest, they don’t have a physicial representation and they only exist as a record in an accounting system. Banks are responsible for keeping records so that every online transaction requires a commercial bank / several commercial banks to update correctly the respective accounts. When a payment is made, the accounts are adjusted by deducting the payment amount from the buyer and crediting it to the seller. For this reason, commercial bank deposits are transacted in a centralized payment system. Even bank reserves are made of virtual money. In most countries public access to electronic central bank money is restricted to a few financial intermediaries, the biggest ones that have to respect usually some criteria. These intermediaries have accounts at the Central Bank, and they use the funds in these accounts for settlement purposes and to fulfill reserve requirements. Central bank electronic money is issued monopolistically and transactions are conducted in a centralized payment system. Base money: also known as central bank money or high-powered money comprises IOUs from the central bank, these include: - currency / cash, which are IOUs to consumers central bank reserves, IOUs to commercial banks. Base money is important because CBs since they issue it in a monopolistic way can implement monetary policies. According to the broader definition of money given before, broad money is the sum of currency and bank deposits that can be easily used to make purchases where currency is an IOU from central bank mostly to consumers, while bank deposits is an IOU from commercial banks to consumers. MEASURING MONEY Changes in the amount of money circuating in the economy are related to 3 factors: - inflation, when inflation grows, people will need more money to buy things so the Central Bank needs to print more of them, reducing the money’s real value. Interest rates, they can both reduce or grow the amount of money in the economy depending on the macroeconomic situation. Output, also known as the GDP. In order to know which monetary policies to adopt in response to different levels of inflation, Central Banks need to know how much money is circulating because as we said before it exists a relation between money and inflation. • How do we measure money? • Which particular assets can be called “money”? The answer depends on the functions of money and is different over time and across countries, as a consequence of different conventions/habits. Since there is a perfect substitutability between reserves and currency, the monetary base (MB or M0) corresponds to the CB liabilities, and it is composed by currency + reserves. MONEY AND THE PAYMENTS SYSTEM The payment system consists of a set of technologies, laws and contracts that allow payments to occur and determine when a payment constitutes settlement. Payment systems include currency, checks, credit and debit cards, electronic funds transfers (EFT), internet banking… The payment system is the method of conducting transactions into a monetary economy, it’s the channel that links economic activity and money. Money is the form of payment and therefore is at the heart of the payment system. If in the payment system is only used cash, there is a decentralized payment system, where cash can change hands between the two agents without the involvement of a third party. In this scenario, buyer and seller need to be physically present at the same location in order to trade. Since there is no third party involved, this system guarantees anonymity of the trade. Recently, innovations in the technology of the payment system have made it possible to pay also via: - Checks, which are instructions (electronic transfer via cash data files) to the bank to transfer money from one account to another, Bank deposits, most of the money now has this form, and their record its kept electronically into banks’ books. These new technologies have made the payment system more efficient, since agents don’t need to be physically present in the same place to do the trade and it also avoids movements of large sums of currency, which was costly and very risky in the past. The electronic payment transfers monetary values electronically via cash data files. These files retain the advantages of physical cash, they eliminate the need of the physical presence at the same location and time of the two agents, and they can be copied any number of times at no costs, generating the double spending problem. In fact, the replication of cash data files corresponds to the duplication of money and so the use of electronic payments comes with the double spending problem. To solve this problem, electronic payments systems are based on an Authority (bank) that receives the delegation to: - Verify the legitimacy of payments, Keep track of the current state of value ownership. With this system, the bank manages the accounts of buyers and sellers and when the buyer initiates a payment by submitting an order, the bank has the role to verify that the buyer has the necessary funds to finalize the payment. For the centralized payments system to work, agents must trust the bank: - Not to misuse its power To maintain correct accounts, keeping orderly track of the electronic operations. Since there is a third party involved (the authority), in this payment system there is a loss of anonymity. CRYPTOCURRENCIES & BITCOIN PRESENT VALUE A dollar paid to you one year from now is less valuable than a dollar paid to you today because a dollar deposited today can earn interest and become $1*(1+i) in one year. The concept of present value is extremely useful because it allows to figure out today’s value of a credit/debt market instrument at a given interest rate by adding up the present values of all the future payments received. Thanks to the concept of present value, we can compare the value of different instruments even if they have very different timing in their payments. YIELD TO MATURITY The Yield To Maturity (YTM) is the interest rates that equates the present value of future cash flows of a debt instrument with its value today. COUPON BOND π Corporations often choose coupon bonds, with their coupon rates computed as πΉ equal to the prevailing (economy-wide) interest rate so that at the moment of issuance, the bond will be trading at par. When this happens, bonds are priced at their face value (P=F). however, after the emission, the economy wide interest rates could change and that could offset the bond’s price. A peculiar coupon bond: the Consol or perpetuity: it is a bond with no maturity date that does not repay principal but pays fixed coupon payments forever. PDV= present discounted value. INTEREST RATES AND RATE OF RETURNS The rate of return is not necessarily equal to the YTM, it will equal it if and only if the holding period equals the time to maturity of the bond. If the holding period is shorter than the time to maturity and there is a rise in interest rates, the bond price will decrease and, as a result of that, there’ll be a capital loss. R is equal to YTM when the capital gain is 0. In fact, by looking at the previous expression, π we can see that by putting g=0, we have π , which is the interest rate. π‘ Interest rate risk: when the interest rate changes, there can be fluctuations in the bond’s price that will lead to a capital gain or loss if the holding period is less than the maturity period. In this case, the rate of return will differ from the YTM. Let’s suppose that we bought a bond 1 year ago, and today the interest rate spikes. If the maturity is far ahead, our bond price will decrease significantly because the more distant a bond’s maturity is, the higher the number of coupons whose present value is negatively affected by an interest rate hike. This bring us to another concept, that is that prices and returns for long-term bonds are more volatile than those for short-term bonds because there is more uncertainty. Even if the bond issuer is the same, in a larger period of time (10, 20 or 30 years) economy wide interest rates can change in the interim and volatility can be much more dramatic. Moreover, you cannot be sure that the default risk of the issuer will be the same 30 years from now! If we decide to hold the bond to maturity, there will not be any interest rate risk because at the end you simply get your money back and the last coupon at the pre-accorded rate. This shows us that treasury bonds are default risk-free, but they have an interest rate risk, in the sense that interest changes can affect their value. Only the most short-term Treasury bills (due overnight) are truly risk-free. DETERMINANTS OF ASSET DEMAND AND THEORY OF PORTFOLIO CHOICE The quantity demanded for an asset depends on 4 factors: - Wealth, which is the total resources owned by an individual, including its financial and real assets. Expected return, Risk, - Liquidity, the ease and speed in which the asset can be turned into money. Holding the other factors constant, the quantity demanded of an asset is positively related to wealth, to its expected return and liquidity, while it’s negatively related to the risk. Bond market equilibrium: there is equilibrium when the quantity demanded is equal to the supply at a given price. - - Expected return: lower expected interest rates in the future increase the expected return for long-term bonds, shifting the demand curve to the right. This happens because the bond that you now own will have a greater return than the ones that will be emitted in the future, and this s why the demand spikes up. Expected inflation: a decrease in the expected inflation rate increases the real expected return for bonds, causing the demand curve to shift to the right. Alternatively, a decrease in the expected rate of inflation might lead to lower expected prices on houses and other real assets creating lower expected capital gains. The relative return on bonds with respect to real assets will increase the demand curve to shift to the right. SHIFTS IN THE SUPPLY OF BONDS - Expected profitability of investment opportunities: a higher profitability for firms investments makes them more willing to finance their own projects. The supply of bonds grows and the supply curve shifts to the right. - - Expected inflation: an increase in expected inflation causes a reduction in the real cost of borrowing. The quantity of bonds supplied will increase, with the curve shifting right. Government budget: when the government has a budget deficit, the supply of bonds will increase shifting the curve to the right, and when it has a surplus the opposite happens. THE FISHER EFFECT When expected inflation rises, bond prices will decrease, and interest rates will rise. As the graph below shows, this result is empirically robust. LIQUIDITY PREFERENCE APPROACH The liquidity preference approach defines the equilibrium interest rate in terms of the supply and demand for money. People store wealth using two assets: - Money M, which earns no interest, Bonds B, which have an expected return of i. The money demand curve is downward sloping since there is an inverse relation between money demand and the interest rate which can be considered as the opportunity cost of money: the amount of interest sacrificed by not holding the alternative asset, the bond. MONEY SUPPLY AND INTEREST RATES: THE ULTIMATE EFFECT - - - Liquidity effect: looking at the previous graph to the right, we can see that if the money supply increases, the demand for bonds will grow, and so its price, causing interest rates to fall. Income effect: income and wealth should grow, causing interest rates to rise. Price-level effect: prices will get to a higher level, and consequently interest rates will rise. This effect will remain even after prices have stopped rising to avoid that they’ll keep growing. Expected inflation effect: it is correlated to the last point. An increase in the money supply leads people to expect higher inflation, that needs to be balanced by an interest rate rise. This effect will stop when the price level stops rising and the expected inflation goes back to zero. ZERO LOWER BOUND AND THE ROLE OF EXPECTATIONS When interest rates are at the ZLB, people expect that they will rise in the future. Hence, they expect that bond prices will fall, and investors are scared of suffering a capital loss if their holding period is less than the maturity period. If the expectation of a rise in rates is large enough, the capital loss could even outweigh the coupon payment and therefore the expected return would be negative. In this hypothetical case, no one would invest their wealth in bonds and they would just keep their money, letting the money demand rise to the stars. Keynes theory: at the ZLB, increasing money supply has no effect on either output or prices, because the interest rates cannot be reduced since they are at their minimum. As a result, of that, if interest rates were to be reduced, they would become negative. The zero lower bound can be reached due to an expansionary monetary policy, as happened after the sovereign debt crisis. With an expansionary monetary policy, with an excess supply of money, people will buy bonds to get rid of their excess money. As a result of that, bond prices will rise, and the interest rate will go down to the equilibrium rate. This doesn’t happen at the ZLB, because investors expect rates to go up and any growth in money supply is hoarded because money demand prevails. Keynes assumed that people believe that interest rates gravitate around a normal value, used to anchor their expectations about the future interest rate level (ππ¬π+π ). So, the decision about wealth allocation is affected by the comparison between current interest rates level and expected future (normal) rates level. RISK STRUCTURE OF INTEREST RATES Bonds with the same maturity have different interest rates due to default risk, liquidity or tax considerations. The relationship among these interest rates is called the risk structure of interest rates. As the graph shows, different categories of bonds with the same maturity have different rates, and their spread varies over time. This spread is influenced by: - Default risk, which is the probability that the bond issuer will be unable or unwilling to make interest payments and/or repay the face value. US Treasury bonds are considered risk-free, while corporate bonds are considered risky assets, but not every corporation has the same default risk and for this reason they are assigned a rating. The lower their rating is, the higher the spread with US Treasury bonds will be. Not all government bonds are considered risk free. For instance, countries with an unstable macroeconomic outlook are considered risky assets, and they could have a significant spread with other countries bonds. In conclusion, it can be shown that the higher the spread, the higher is the implied probability of default. Let’s assume that there are 2 countries in the world, an advanced one issuing risk-free bonds, paying an interest rate β $ and an emerging economy issuing risky government bonds denominated in US Dollars, with an interest rate β ∗ . These bonds are equivalent in every aspect, apart from their default risk. If an investor considers these bonds as perfect substitutes (with the exception of riskiness), he must earn the same expected return. If he is a risk-neutral investor, he’s indifferent in investing in the risk-free asset or in the risky asset if and only if: The spread reflects also: - - Liquidity, the relative ease with which an asset can be converted into cash considering both the cost of selling a bond and the number of buyers/sellers in a bond market. Income tax considerations, for example, interest payments on municipal bonds are exempt from federal income taxes and for this reason they have lower rates than Treasury bonds. YIELD CURVE OR TERM STRUCTURE OF INTEREST RATES The yield curve, also known as the term structure of interest rates, is today’s average annualized interest that investments pay as a function of their time to maturity. It describes the relation between bond yields and their maturities. The curve can be: - Upward sloping, long term bonds have a higher rate than short-term bonds (normal situation). Flat, they are equal. Inverted, long-term bonds have a lower yield than short-term bonds (followed often by recessions). A good theory of the term structure of interest rates must explain the following facts: 1. Rates on bonds of different maturities move together over time 2. When short-term rates are low, yield curves are more likely to have an upward slope, while when they’re high, yield curves are more likely to be inverted. 3. Yield curves almost always slope upwards. In the 2008 crisis, there was a heavy recession that was anticipated by the short-term bonds having a better yield than the 20 yrs ones (the yield curve was inverted). EXPECTATIONS THEORY Let’s assume a two-asset world: - One-year bond, offering a rate at time t equal to β π‘ Two-year bond, with a rate at time t of β 2,π‘ . These two assets are equivalent in everything, apart from their maturity. Let’s consider that we have in this world also an investor, that considers these bonds as perfect substitutes. For this reason, it is indifferent for her holding one bond or another if they have the same expected return. Expected return 2 yrs bond to maturity: 2 (1 + β 2,π‘ )(1 + β 2,π‘ ) − 1 = 1 + 2β 2,π‘ + (β 2,π‘ ) − 1 ≈ 2β 2,π‘ The return of an investment on a 2 year bond held until maturity corresponds to two coupons paying an annualized interest rate equal to β 2,π‘ . Expected return 1 year bond rolled over until the end of the second year: π ) π π ) π (1 + β π‘ )(1 + β π‘+1 − 1 = 1 + β π‘ + β π‘+1 + β π‘ (β π‘+1 − 1 ≈ β π‘ + β π‘+1 The return from the roll-over strategy corresponds to two coupons, being the yearly certain interest rate and the forward rate, which is an expectation of the one-year rate at time t+1. The investor will held both bonds if and only if: ππ + πππ+π = πππ,π Two-year rate: ππ + πππ+π ππ,π = π This means that the two-year coupon rate must be equal to the average of the current and expected one-year rates. The previous example shows us that if the forward rate is expected to be higher than the current one, it produces an upward sloping yield curve. Forward interest rate: πππ+π = πππ,π − ππ = ππ,π + (ππ,π − ππ ) Where (ππ,π − ππ ) is the yield spread, which is the difference between long-term and shortterm rates. When the yield curve is positively sloped, it means that the yield spread is positive. For this reason, the forward rate is higher than the current rate, which brings us to conclude that the long-term rate is higher than the short-term one (see the slide below). To sum up, expectations theory explains: - - Why interest rates on bonds with different maturities move together over time because when short-term rates increase today, they will tend to be higher in the future since a rise in short-term rates will higher up expectations. Moreover, since long-term rates are just the average of forward short-term rates, a rise in the current short-term rates will rise also long-term ones. Why yield curves tend to slope up when short-term rates are low and slope down when they’re high. As Keynes said, when these rates are low, people expect them to reach their normal level in the future, causing the yield curve to slope up. The opposite situation happens when they’re high. SEGMENTED MARKET THEORY As its name suggests, this theory does not consider bonds with different maturities as perfect substitutes. The interest rate for each bond is determined by the demand and supply of that specific bond in its specific market. This theory is based on the fact that investors have preferences for bonds of one maturity over another for several reasons, such as their desired holding period. The segmented market theory can explain why yield curves usually slope upward. Investors usually prefer bonds with shorter maturities because they have a lower interest rate risk. Hence, the demand for short-term bonds is relatively higher than the one for longterm ones, causing short-term bonds to have a higher price than long-term bonds with lower rates. This explains why the curve slopes upward. LIQUIDITY PREMIUM & PREFERRED HABITAT THEORIES Bonds of different maturities are partial substitutes. With this consideration, we can say that the expected return of a bond affects the expected return of a bond with a different maturity but it allows investors to prefer one bond maturity over another. The long-term rate on bonds will equal an average of short-term rates expected to occur over the life of the long-term bond plus a term premium (liquidity premium, πππ ) that responds to supply and demand conditions for that bond and that usually rises with the term to maturity of the bond (n). ππ,π = ππ + πππ+π + β― + πππ+(π−π) π + πππ Preferred habitat theory: investors prefer investing their money on short-term bonds. The only reason why they consider the possibility of investing in long-term bonds is if they earn a higher expected return. The graph below perfectly illustrates this theory. Case A Steepness is due to expected rising short-term rates as well as a rising maturity premium as maturity lengthens. Case B Rates are expected to rise, but not by much. Case C The yield curve is flat because short-term rates are expected to decline, but this decline is counterbalanced in the long-term by the liquidity premium. Case D Short-term rates are expected to fall sharply, affecting the liquidity premium. We can now say that empirical evidence suggests that long-term bonds have a higher yield because they’re considered riskier, in terms of interest rate risk, and for this reason investors expect a higher return. But why the yield curve is very steep if a strong expansion is expected? The long-term rates are expected to be higher because if the economy grows, so will the prices (inflation) and rates must be higher in the future to avoid iperinflation and to guarantee to investors the same level of real interest rates. When the yield spread is negative (yield curve inverted) there has historically been a 90% probability of an incoming recession within 4-8 quarters. But why when there is suspect of a recession, the yield curve is inverted? Empirical research shows that people expect that short-term rates will decline until the economy’s performance improves. This rate reduction is a monetary policy needed to stimulate the economy. According to the expectations theory, a future reduction of short-term rates will lead to an immediate reduction of long-term rates, and that happened on several occasions prior to recessions. Since short-term rates are higher than long-term rates, to reconcile long-term rates with expected short-term rates it is needed the existence of a time varying term premium so that: ππ,π = ππ + πππ+π + πΜππ+π + β― + πππ+(π−π) π + πππ Role of the term premium: the term premium or liquidity premium cannot be observed directly in financial markets and it is estimated by subtracting the expected rates at every point in time from whatever they really are. To give it a definition, the term premium is the extra return that investors demand for holding a long-term bond instead of investing in a series of short-term securities over time. On the other hand, it is what borrowers offer to convince investors to hold this longterm bond instead of short-term securities. WHAT DRIVES CHANGES IN THE YIELD CURVE OVER TIME? Changes in monetary policy: a conventional monetary policy tends to shift the level of the yield curve up and down, particularly in the short end. On the other hand, unconventional monetary policies (Unco) can change both the level of the yield curve (e.g. through negative rates that lower the entire yield curve) and its slope (e.g. through forward guidance & asset purchases). If the central bank wants to reduce inflation, it applies a tightening monetary policy that higher short-term interest rates. As a reaction to this, long rates increase too, but not as much as short rates because a policy reversal is expected when inflation will be again under control. Changes in fiscal policy: if the government decides that for example wants to issue more 10 years treasury bonds to finance its deficit (and this is the only category of bonds it wants to issue more), this increase in supply will let price drop and interest rates will grow, steeping the yield curve more. Changes in investors’ perception of risk: The credit risk is the risk that the bond issuer won’t be able to meet its payment obligations, both for coupons and for the amount borrowed. Usually, government bonds do not or have a very little credit risk, but if they have this risk, they need to pay a sovereign spread. The liquidity risk happens when it is very difficult to sell an asset. This is a very rare event for government bonds, that could though happen in situations of financial distress. If the investor invests in a bond with a fixed rate, he is exposed to the term risk. In fact, the interest rate might rise in the future, and the investor by subscribing a long-term bond with a fixed rate will obtain a lower return than if he invested in multiple short-term bonds. This risk is measured by the term premium. FINANCIAL MARKETS Financial markets are critical for generating an efficient allocation of capital, moving funds from people that lack productive investment opportunities to people who have them. They are also critical for improving the well-being of consumers, allowing them to time their purchases better. - Direct finance, borrowers borrow funds directly from lenders in the financial markets through financial instruments, Indirect finance, borrowers fund themselves through financial intermediaries, that help both borrowers and lenders to satisfy their demand for funds and financial instruments respectively. STRUCTURE OF FINANCIAL MARKETS Flow of funds account: it is a compact representation of the financial transaction of each different unit/sector of the economy & among themselves. These units are: - Households Non-financial corporations Government Rest of the world. Hence, the flow of funds account measures financial flows across sectors of the economy, tracking funds as they move from the surplus units to the deficit units through intermediaries. Closed economy: total financial assets must be equal to total financial liabilities. As a result of this, we can say that the wealth of a closed economy is equal to the value of its real assets (not financial). While prices in primary markets are often set beforehand, in the secondary markets prices are a result of supply and demand for that specific financial instrument. The presence of arbitrageurs, always ready to make extra profits, impedes the divergence of prices between primary and secondary markets. FINANCIAL INTERMEDIARIES A financial intermediary is the middleman of financial markets: it obtains funds from savers and then he makes loans to borrowers. Financial intermediation is useful for reducing: - - - Transaction costs, they reduce them with economies of scale and their expertise. For example, writing a contract can be expensive, but FIs standardize them and they’re able to save money both for them and their clients as the number of clients increases. Low transaction costs implies that also they can provide customers with liquidity services, that are checking accounts and saving accounts, and in both of them the depositor can earn an interest. Risk sharing, as a mean to reduce uncertainty on returns. Depositors expect to have an interest on their money and banks, thanks to their low transaction costs, are able to deliver it by asset transformation. Asset transformation consists in getting capital from depositors (short-term) and using it to buy assets with a different set of characteristics and maturities (long-term loans or even different financial assets). The profit for FIs consists in the difference between returns on risky assets and the funding costs, net of transactions costs. Transaction costs are very low as we said before. Even if deposits tend to be small, they are not costly for FIs that bulk them together to transform them into large long-term loans. Again, low transaction costs allow FIs to do portfolio diversification, as they can buy a range of assets whose returns are not correlated, pool them and sell them to customers as if they were a new, single financial asset (typical of mutual funds). Asymmetric information, there is asymmetric information when one party doesn’t reveal all the information he has to his counterpart, causing problems of adverse selection or moral hazard, that can occur respectively before and after the transaction occurs. Asymmetric information obviously reduces market efficiency. FIs themselves can reduce market efficiency because of conflicts of interest. Since they provide multiple services, such as investment banking, auditing and consulting, and rating agencies, one area of the FI could hide relevant information to another one in order to not lose the client. For this reason, these services are very regulated. WEALTH The first element defining wealth is the stock of gross assets, which are the result of the sum of tangible assets (or non-financial assets, such as housing, other buildings, and land), and financial assets (bank deposits, corporate stocks and bonds). But since to buy assets people or corporations or governments might have to borrow funds, any outstanding liability or debt must be subtracted to gross assets to define net worth or wealth. These outstanding liabilities are the financial liabilities (FL), which include: mortgages, credit card debt, automobile loans… So, to define wealth: net worth or wealth = gross assets – financial liabilities. However, since in a national balance sheet all claims of one national against another and all holdings by a national of equity in domestic business enterprises are eliminated, it follows that the stock of domestic financial assets is equal to the stock of domestic financial liabilities. So, in a national balance sheet of an open economy the only assets that remain are tangible assets and net claims against foreigners (Net International Investment Position). Net International Investment Position (NIIP) or net foreign wealth or net foreign assets: it includes foreign assets and liabilities held by a nation’s citizens, private sector and governments. It determines whether a country is a creditor or a debtor with the rest of the world and it is the difference between its foreign financial assets and liabilities. T-account balance sheet: it is a simplified balance sheet where only the changes that occur with respect to initial positions are reported. THE BANK BALANCE SHEET Banks fund themselves by collecting capital, by issuing liabilities such as deposits and by borrowing. Its liabilities are: - - Bank capital, it is raised by selling equity and it is very important because it serves as a cushion against a drop in the value of the bank’s assets. Deposits, o Checkable deposits, they are the cheapest way to get funds because the bank pays for it no interest or a very low one o Non-transaction deposits, they cannot be withdrawn by depositors on short notice and for this reason they have a higher interest rate o Other banks’ deposits, they are very short-term liabilities (overnight) from other banks in the interbank market Borrowings, the bank issues bonds or certificates of deposit, or again very shortterm operations undertaken with other banks in the interbank market. Bank assets: bank use obtained funds to purchase income-earnings assets, which are: - Reserves, required and excess reserves held at the central bank, Cash items, in process of collection, Deposits at other banks, short-term loans, Securities, such as government bonds, commercial paper, private sector bonds… Loans, it is the most common asset for commercial banks Other assets, physical capital such as buildings. BASIC BANKING In technical jargon, a bank usually borrows short and lends long. For instance, a bank transforms saving deposits into mortgage loans, and it is able to do that thanks to the law of large numbers, as they do not expect all the short-term depositors to ask back their money at the same time. Banks’ sources of profits: - Interests on loans, Interest from fixed income securities (government bonds and commercial paper), Commission income, fees for various financial services provided Net trading income, from buying and selling financial securities. LIQUIDITY MANAGEMENT On the other hand, if a bank doesn’t have excess reserves, it needs to liquidate some of its assets when a deposit outflow happens. This is a costly operation because if the bank has an emergency, it might liquidate its assets at a lower price than their fair value or it might borrow from other banks in the intrabank market or to the CB, but then they would have to pay an interest on the loan. The last option that they would have is to reduce their loans, meaning that they either do not renew loans when they come due, or they sell loans to other banks or they demand their money back before the term they agreed on the contract. The cost associated with this decision is the cost of losing the client, that won’t go again to the same bank if he wants a loan in the future. For these reasons, it is less costly for the bank to keep excess reserves, even if they have an opportunity cost because these funds are not used to purchase assets. To sum up, we can say that excess reserves are insurance against the liquidity risk. The case of the GFC: in normal times, before the GFC, the intrabank market was working very well thanks to a high level of liquidity. A good measure of its liquidity is the TED, Treasury Bill to Eurodollar Rate spread, which is the difference between the rate banks can lend to each other over a 3 month period (LIBOR) and the rate at which government is able to borrow money for a 3 month period. TED spread is an indicator of risk from one bank lending to another, reflecting both liquidity and credit risk. When the crisis erupted, liquidity dried up immediately and the interbank market stopped working smoothly and counterparty risk skyrocketed, with the TED going from its average of 40 bps to an impressive 450 after the Lehman collapse. CAPITAL ADEQUACY MANAGEMENT Banks decide how much capital they need to hold based on 3 reasons: - To prevent bank failures, a situation in which the bank cannot satisfy its obligations to depositors and creditors, Bank capital affects return for the shareholders of the bank, the higher it is, the less the return for them, Bank capital is needed to satisfy regulatory requirements. Hence, we can say that a large enough cushion of bank capital lessens the chance that the bank will become insolvent, but the size of bank capital is negatively related to the rate of return for shareholders, meaning that the bank has to solve a trade-off between safety and returns. How bank capital affects returns: shareholders, if they want to check how their bank is doing, can use the net operating income to measure its profits, which is the difference between operating income & operating expenses. The problem of this measure is that it is not adapted to the bank size, making it difficult to compare it with its competitors. A second measure that allow to compare banks is the net interest margin, which is the difference between interest income and interest expenses as a percentage of total assets. π΅π°π΄ = π°πππππππ π°πππππ − π°πππππππ π¬πππππππ π¨πππππ If a bank is well-managed, it earns high income on its assets and has low costs on its liabilities. As a result, profits will be high. Another measure is ROA that indicates the profit generated by each dollar of assets: πΉπΆπ¨ = π΅ππ π·πππππ π¨ππππ π»ππππ π¨πππππ Then there is also the ROE, that shows how much net profit is generated by each dollar invested in equity: πΉπΆπ¬ = π΅ππ π·πππππ π¨ππππ π»ππππ π¬πππππ πͺππππππ EM is higher the lower is the equity capital!!! This is a very important conclusion when we compare the profitability of banks having the same ROA but different EM. If two banks have the same ROA but different equity capital, the company with the lowest capital will deliver greater results to its shareholders. Using the notion of leverage ratio (LR), it’s clear how an increase in EM might be a result of an increasing use of debt to fund or undertake an investment project. Instead of issuing new equity capital, a less costly way to undertake investment project is to indebt themselves to increase shareholder value. The ultimate outcome of this strategy is that if the project is profitable, there’ll be higher returns, while if it is unprofitable there’ll be a higher potential downside risk. This again highlights that the bank has to solve a tradeoff for its shareholders between safety and returns, and their choice depends on the state of the economy, the levels of confidence and the regulatory framework. When a large number of banks suffer from a capital shortfall, as happened in the GCF, a credit crunch occurs, with severe implications for the economy, that could also bring to recessions. MANAGING INTEREST RATE RISK This shows that if a bank has more rate-sensitive liabilities than assets, a rise will reduce its profits, while a fall will raise them. Usually, banks are exposed heavily to rate risks since they have a lot of fixed-rate assets, such as long-term loans and then they have lots of rate-sensitive liabilities, like money market deposit accounts and variable-rate CDs. YIELD CURVE RISK Yield curve risk is due to a shift in the yield curve in which yields don’t change by the same number of basis points for every maturity, meaning that short and long-term rates don’t change in parallel ways, but often there is a pivot point in the curve after which long-term and short-term rates change in different amounts. GAP ANALYSIS Income gap: it is the difference between rate sensitive assets and rate sensitive liabilities. To get a sensitivity of bank profits to interest rate changes we need to multiply the income gap with the change in interest rates. DURATION ANALYSIS Sensitivity to interest rates changes is based on duration, which measures the average lifetime of a security stream of payments. This analysis uses the weighted average duration of a bank’s assets and liabilities to compute how net worth responds to changes in interest rates. OFF BALANCE SHEET ACTIVITIES Loan sales: the bank sells all or part of the cash stream of a specific loan. They usually make profit from this operation because they sell it at a greater amount than the one of the original loan. By doing so, the bank removes the loan from its balance sheet so that its reserve requirements will be lower. This is a way to economize on capital requirements. Generation of fee income: income generated from fees that the bank gets for providing specialized services, such as: - Servicing mortgage-backed securities, by collecting interest and principal payments and then paying them out, Guaranteeing debt securities, if the issuer of the security won’t be able to meet its obligations, the bank will for him. This can potentially expose the bank to a risk. Creating SIVs, (structured investment vehicles) which can too expose banks to risks, as happened in the GFC. Trading activities and risk management techniques: trading activities are highly profitable but very dangerous, because they’re exposed to principal-agent problems. For instance, a trader working for a financial institution wants to risk more to bring a higher return to the firm because in case of large profits he’ll have a higher bonus or even a promotion. But if things don’t go to plan and he loses money, the FI will have to cover them. In this case, the trader is the agent, and the FI is the principal. Even though these activities are not visible, they expose banks to relevant risks. Hence, bank management should pay a lot of attention to risk assessment procedures and internal controls in order to limit employees from taking too much risk.
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