Financial Markets and
Institutions
FIN 712
I. General Introduction
Course Objectives
• Dynamic picture of markets (interest rates)
• Structural evolution of markets
– Financial innovation (and regulatory response)
– Why market has its current structure
Managerial implications
1. Level and structure of interest rates
•
Impact on financing decisions?
2. Structure of financial sector: Why so
many financial instruments ?
•
Which one is best suited?
Some sources of data
• Wall St. Journal: “Markets Data Center”
http://online.wsj.com
• St. Louis Fed (data repository of system)
http://research.stlouisfed.org/fred2/
• Federal Reserve: Board of Governors
http://www.federalreserve.gov/
TANSTAFL
The Answers
1. Gains from Trade
•
Consumer/producer surplus
• “Win – Win”
2. Transaction cost minimization
The Answers
1. Gains from Trade
•
•
Differences lead to gains from trade
Instruments exist to realize gains from trade
2. Transaction cost
•
Transactions are structured to minimize cost
GFT & Transactions Costs
• Tell us directly why instruments and
intermediaries exist.
• Are also central to understanding the
behavior of interest rates
– Because understanding supply and demand for
an instrument requires us to understand how it
creates GFT
Introduction: How markets change
Junk Bonds: An Example of Financial
Innovation
Key ideas related to finanial
innovation:
• Benefits of markets (and financial innovations)
economic concept of Gains-from-Trade
• Hazards – unintended results of financial
innovation and how they are handled.
– Market responses – design changes implemented
by market participants (further innovations)
– Regulatory responses – continuing interaction of
regulators and participants
• Continuing cycle of innovation and reaction
One innovation: The case of ‘junk’
bonds
• “Junk” bonds
– These are below investment grade: rated BB or
lower, also called “high yield” bonds.
– Traditionally existed only when originally
investment grade bonds were downgraded –
“fallen angels”.
The innovation
• Beginning about 1980, Michael Milken
began encouraging corporate borrowers to
sell bonds rated below investment grade at
issue.
– Clients who could not qualify for an investment
grade rating,
– Or issues deliberately structured to have a
lower rating.
The sell side: bond issuers
Junk bonds were particularly attractive to:
• Issuers not well known to the market
– e.g. new technologies of the time
– “disintermediation” of the 1970s had reduced
banks’ willingness to fund less well-know
borrowers.
• Later became a popular means to finance
corporate takeovers – creating leveraged buyouts.
Building the buy side of the market:
the sales pitch
• Milken asserted aggressively that the
default probability for these bonds was
much lower than what was allowed for by
their higher yield.
– He argued the ratings agencies were irrationally
conservative in their evaluation of risk.
• Initially, the data seemed to support him.
Building the buy side (2):
providing liquidity
• Milken assured buyers that Drexel Burnham
Lambert would always make a market – be
willing to buy or sell – bonds they placed.
• Promised liquidity increased the value of
the bonds to purchasers.
Building the buy side (3):
Result: Market concentration
• As a result, both the primary market (initial
issue) and secondary market (trading after
issue) were concentrated in Drexel.
• Milken had an unassailable informational
advantage about who held what, who was
willing to buy what.
• Reinforced the his advantage in placing
newly issued bonds and controlling the
market.
Market growth during 1980s
• The market grew rapidly
– Junk bonds outstanding 1979
– In 1989
$ 10 billion
$189 billion
• Financed growth of emerging industries
– Turner Broadcasting
– MCI Telecommunications
• Widely used to finance corporate takeovers
– Leveraged Buyouts (LBOs)
Late 1980s
• Default experience began to deteriorate
• Michael Milken was investigated
– for insider trading related to some of the junk
bond financed LBOs.
– for market manipulation of junk-bond prices.
End of the decade
• The junk bond market collapsed as Michael
Milken’s legal problems mounted:
– Indicted 1989
– In a plea bargain, pled guilty to securities
violations
– Fined, spent almost 2 years in jail, barred from
the securities industry for life.
• Junk bond issuance in 1990 – virtually zero
Junk bond market since 1990
• Junk bonds outstanding
–
–
–
–
–
1979
$ 10 billion
1989
$189 b
1990
$181 b
1999
$567 b
Similar magnitude today
Junk Bonds: Further Question
• Why has the market continued to grow
since 1990?
– Benefit to borrowers?
– Benefit to investors?
Case
Summary
Key Issues for Any Financial Innovation
Application to Junk Bonds
• Benefits derived from markets
– Purpose or reason markets exist
– Drivers of financial innovation
• Potential problems with market functioning
– Ethical or “moral hazard” issues
– Other issues
Case Summary (continued)
• Consequences of these problems, including
financial crises
• Appropriate responses
– Market driven responses
– Regulatory responses
II. Loanable Funds Theory
(The Fisher Model )
The Fisher Model
• We begin with the simplest possible case:
the market for generic loans
• Questions addressed:
– What determines the overall level of interest
rates in the economy?
– What is the source of GFT in this market?
Why is the economy better off when there are
capital markets?
Example: history of interest rates
http://research.stlouisfed.org/fred2/series/GS1
?cid=47
Fisher Assumptions
1.
2.
3.
4.
5.
No inflation
No taxes
No uncertainty
Two-period world
No transaction costs
This list of assumptions is also an outline
for the first part of the course:
• Relaxing each one in turn lets us examine
another dimension of the structure of
interest rates.
• It also reveals an additional source of gains
from trade.
Fisher Model
Outline of Topics
•
•
•
•
Demand for loans (business)
Differences and Gains from Trade (GFT)
Supply of loans (households)
Summary and lessons
Simple numerical example:
Business demand for loans
• How business demand for loans is
determined (PV maximizing borrowing)
• Key lesson: What information governs this
decision
– What shifts the demand curves/interest rate
– What are sources of GFT
Numerical example: information
Productive Opportunity
Invest.
1
2
3
4
5
6
Output
5.5
10
13.5
16
17.5
18
Numerical example: information
Endowment:
E=1
Market interest rate: 100%
r = 1.00
r = interest rate/100
if B = borrowing, repayment = B*(1+r)
Numerical Example
• What level of borrowing maximizes profit
(value of firm)?
Lessons from the numerical example
1. Optimal decision rule: MP(B) = 1 + r
Decision rule determines:
2. Choice of how much to borrow
3. Quantifiable gain from being able to trade
on the market (borrow or lend).
From decision rule to demand curve
1. MP(B) = 1 + r
2. Diminishing returns
How does borrowing respond to changes in r?
Why?
Definition: demand curve
• Demand curve shows desired quantity of
borrowing as a function of the interest rate.
• Or, the other way around: Demand curve
shows the interest rate at which a given
quantity of borrowing is optimal.
• Either way, demand curve relates interest
rate and amount of borrowing
Lessons from numerical example (2)
4. Optimal decision rule generates the firm’s
demand curve for loans
•
Note that this can become a supply curve when
interest rates are high enough.
5. Demand curve affected (only) by factors
influencing firm’s borrowing decision
•
•
Production opportunity
endowment
Algebraic version of example
information
Endowment:
E=1
Production opportunity:
MP = 6 – I
[This is the derivative of the production function
Q=6I – 0.5I2]
MP = marginal product
I = investment
Q = output
Algebraic example:
Deriving demand curve
Decision rule
MP = 1+ r
Production opp.
6 - I = 1+ r
Budget constraint requires I = E + B, so
6 – E – B = 1+ r
With E = 1, this solves to
B = 4 – r or r = 4 - B
Graphical representation
B = 4 – r or r = 4 - B
Algebraic example:
factors affecting demand curve
r=5–E–B
as endowment increases, quantity demanded
at any interest rate decreases (the demand
curve shifts in or down)
Algebraic example:
factors affecting demand curve
r = MP - 1
As productive opportunities improve - MP
increases for each amount of investment quantity demanded at each interest rate
increases (the demand curve shifts out or
up)
Algebraic example:
quantity demanded
• Given any interest rate, the demand curve
determines the desired quantity borrowed.
• For example, if r = 1 (interest rate = 100%)
B=4-1=3
Algebraic example: Gains from trade
Demand curve
r = MP – 1
• The height of the demand curve at any point
is (essentially) marginal product of
investing one more dollar.
• The market interest rate is cost of borrowing
• The difference is the gain from borrowing
and investing that dollar.
Graphical example: quantity demanded
Graphical example: gains from trade
Algebraic example:
Gains from trade calculation
Area of a triangle
= (1/2)*base*height
GFT triangle
GFT = 0.5*B*(4 – r)
Calculation:
GFT = 0.5*3*3 = 4.5
Lessons from algebraic example
1. Demand curve for loans
2. What factors can shift the demand curve
3. GFT can be quantified from the demand
curve
4. The same factors affect GFT
Supply Curve of Loans
• Depends on household behavior
Deriving Supply of Loans
• Household behavior is analogous to that of
firms
• But depends on
– Taste for current versus future consumption
– Endowments
Market interest rate
• Aggregate (add horizontally) individual
demand curves to derive market demand
• Aggregate individual supply curves to
derive market supply
• The market interest rate equates quantity
demanded and quantity supplied
(intersection of the curves).
Lessons about the level of interest
rates
• Interest rates can be changed by any factor
that shifts the supply or demand for loans.
– Note: a change in interest rates (price) does not
shift a supply or demand curve.
– Any information (other than the interest rate)
used to decide quantity demanded can shift a
supply or demand curve
Example: Differences and GFT
Lessons about GFT
•
•
•
GFT = benefit from creating a market
GFT are reflected in demand and supply
curves
GFT result from differences
Summary of Fisher Model
Factors that can change interest rates/create
gains from trade in the Fisher Model
1. Productive opportunities
2. Taste (current v. future consumption)
3. endowments
III. Applying the Fisher Model
Applying the Fisher Model
A useful stylization
• Firms demand loans
• Households supply them
Applying the Fisher Model:
Underlying thought process
1. What could change r?
[a shift of the supply or demand curve]
2. What could shift a curve?
[productive opportunities, taste,
endowments]
3. What event(s) described in the article
could change any of these?
Applying the Fisher Model
Telling the story/How I grade
1. Relevant event in article
2. Which factor in the model is affected and
why.
3. Which curve shifts? Which way? Why?
4. Resulting change in equilibrium.
Discussion question: example
Key points of this class
1. Differences = GFT = financial instruments
2. In the Fisher model, the factors that can
produce GFT and/or change interest rates:
•
•
•
Production opportunities
Taste (current v future consumption)
Endowments
3. Steps to use Fisher Model to explain
changes in interest rates