Financial Markets,
Institutions &
Derivative
Instruments
ECO 473 – Money & Banking – Dr. D. Foster
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Match savers and investors
◦ Savers want to  wealth
◦ Investors want to create wealth
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Spread/share risk.
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Successful strategy - diversification
◦ Savers seek out mutual funds
◦ Savers seek out financial intermediaries
◦ Investors seek OPM
Financial Markets - Why & Who
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Why - Intermediation
Who . . .
banks
credit unions
S&Ls
thrifts
savings banks
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pension funds
Insurance companies
mutual funds
mortgage brokers
investment bankers
finance companies
Financial Markets - New & Used
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New - Primary Markets
◦ stocks (IPO), bonds, mortgages, other.
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Used - Secondary Markets
◦ exchange of ownership.
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Where: NYSE,
NASDAQ,
OTC . . .
Financial Markets - Short & Long
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Short - Money Markets
◦ A financial instrument that matures
w/in one year.
◦ Used to facilitate liquidity demands.
 Need funds soon.
 Have excess cash.
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3 mo. & 6 mo. T-Bills
Commercial paper
Bank CDs
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Fed’l funds
Repurchase agreements
Bankers’ acceptances
Euro$ funds
Money Market Instruments Outstanding, 2000-2012
Financial Markets - Short & Long
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Long - Capital Markets
◦ Maturities of more than one year.
◦ Used for capital purchases (investment).
◦ Less liquid & more risk than MM.
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Corporate stock
Corporate bonds
U.S. Treasury bonds
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Other U.S. & Munis
Mortgages
Comm./Con. loans
Financial Institutions
Mutual Funds
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Sell diversification to individual savers.
Government regulations limit risks.
8,000 mutual funds in the United States.
Hedge Funds
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Raise money from wealthy people/institutions
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Largely unregulated
◦ Use leverage which magnifies gains/losses.
◦ Trade in derivative instruments.
Brokers and Dealers
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A broker buys and sells securities for others
◦ May be “full service” or “discount.”
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A dealer buys and sells for itself,
making a market in these securities.
Investment Banks
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Underwrites and advises companies on mergers
and acquisitions.
Investment banks buy and sell securities and
derivatives.
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1930s Regs/diversification option?
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2008 - collapse of the MBS market.
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Bear Stearns - couldn’t roll over debt.
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Lehman Brothers - $639 bill. in assets.
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Merrill Lynch - sold to BoA
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Goldman Sachs & Morgan Stanleyconverted to commercial banks.
Derivative Financial Instruments
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Forward contracts
Future contracts
Options
Swaps
Derivatives in . . .
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Interest rates
Currency
Stock
Commodities
Weather
“Purpose” of a Derivative
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Hedging/Insuring against adverse changes …
You have $10 million in U.S. Treasuries,
nominal yield is 5% and maturity date is 3 years
from now. But, you only want to hold them for one
more year.
Risk – If interest rates rise, the price will fall.
Hedge – execute a forward contract, promising to
sell bonds in 2009 at a price yielding 5.1%.
“Purpose” of a Derivative
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Hedging/Insuring against adverse changes …
You need to buy €5 million in 6 months,
the current exchange rate is $1.33/ €. But, you
think the dollar will depreciate by then.
Risk – If the dollar falls, it costs more to buy €.
Hedge – go “long” and agree to buy €, through a
futures contract, at $1.36 each.
Forward vs. Future Contract
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Forward:
◦ Variable in content.
◦ Settled at maturity date.
◦ Matching participants.
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Future:
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Standardized amounts and terms.
Ongoing settlement cash flows.
Active, liquid market.
Default can’t hurt other party.
“Purpose” of a Derivative
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Hedging/Insuring against adverse changes …
You need to buy €5 million in 6 months,
the current exchange rate is $1.33/ €.
But, you think the dollar will depreciate by then.
Risk – If the dollar falls, it costs more to buy €.
Alternative Hedge – buy a call option to purchase
Euros at $1.40 each; exercise only if the rate moves
higher than that.
“Purpose” of a Derivative
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Hedging/Insuring against adverse changes …
You pay a variable return on $25 million worth of
outstanding bonds.
Risk – If interest rates rise, so do your costs.
Hedge – execute an interest rate swap, to gain a
fixed payment schedule, and reducing your
exposure to interest rate changes.
Derivatives as speculative
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Bank agrees to buy bonds in one year at a price
that earns 5% . . . thinking rates will fall.
Buy/sell currency futures if you expect rates to
move contrary to market.
Buy options to leverage your investment.
Actions raise market liquidity for non-speculators!!
Case: Barings Bank - 1762 to 1995
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1992 – Nick Leeson becomes a trading manager at
Baring Securities in Singapore.
Charged with executing client option orders and
arbitraging price differences between SIMEX and
Osaka exchanges.
Took “speculative positions” in futures linked to Nikkei
225 and Japanese gov’t. bonds.
Hid losses in an unused error account:
$400 m. – 1994 and $1.4 b. – 1995
Fled Singapore; arrested in Germany.
The Credit Swap Derivative
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Hedging against adverse changes..
You own $25 million worth of
outstanding bonds.
Risk – If the firm goes bankrupt . . .
Hedge – buy a credit default swap, and
make a fixed payment (insurance). If
firm goes bust, the seller owes you for
the bond (difference).
The Credit Swap Derivative
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First one in 1995 (J.P. Morgan)
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By 2008, $45 trillion in value.
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As speculation – buy & sell to manage risk.
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You don’t need to own bond!
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Done OTC.
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Party-to-party transaction.
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Settlement/liquidity issues.
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Build a virtual bond portfolio.
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Insider trading issue . . .
Financial Markets,
Institutions &
Derivative
Instruments
ECO 473 – Money & Banking – Dr. D. Foster